If you are a dividend-focused investor, one of the most critical financial metrics you can analyze is the payout ratio to determine the dividend’s sustainability in the future. But what exactly is a good dividend payout ratio? How do you determine which company should have a lower or higher payout ratio?
In this guide, we’ll go over some of the most important considerations you should analyze when determining what a good dividend payout ratio is.
What is the dividend payout ratio?
The payout ratio or the dividend payout ratio is a financial metric that measures the percentage of earnings of a company that are paid out to shareholders in the form of dividends. Therefore, the payout ratio allows investors to assess whether the company’s dividend is sustainable and whether or not it represents a large percentage of the company’s profits.
The payout ratio also allows investors to determine whether the company will be forced to cut its dividend and whether or not it is actively investing in improving the business and its operations.
Dividend payout ratio formula
The dividend payout ratio is extremely easy to calculate, and there are two methods to do it:
Dividend Payout Ratio = Dividend Per Share / Earnings Per Share
Dividend Payout Ratio = Total Dividends / Net Income
What does the payout ratio indicate?
While on the surface, the dividend payout ratio only indicates the percentage of earnings that the company is distributing to its shareholders, there are other conclusions that investors can make from this financial ratio.
Here are some of the most important considerations you can make based on the dividend payout ratio:
One of the most important things that the payout ratio indicates is dividend sustainability. If you are investing in a stock that pays a dividend, you want to ensure it is sustainable and won’t be halted or cut. Not only will you receive less money in the form of dividends, but the stock price will also decline following a dividend cut or halt.
Another important aspect of analyzing the dividend payout ratio is understanding how much capital the company is reinvesting in itself. Some companies are mature and do not require a lot of constant investment. Additionally, their maintenance Capex might be low so that they can distribute most of the profits to shareholders.
What you need to look out for are companies in competitive industries that are perhaps distributing too much of their profits to shareholders and end up becoming uncompetitive due to the lack of reinvestment in the business.
Finally, the dividend payout ratio can also give investors a glimpse into how the stock might perform going forward. Whenever a company distributes a high percentage of its earnings as dividends, the stock price is unlikely to go up. The reason is that if the dividend yield is high and the payout ratio is also high, the company is paying a large percentage of its market cap in dividends.
Therefore the money that is going out of the company in the form of dividends makes the whole company worth less money in total. Additionally, a high dividend yield and high payout ratio could indicate that the stock is risky, and therefore investors should be aware and cautious of these types of stocks.
How to analyze payout ratio
When analyzing the payout ratio of a stock, you want to consider a multitude of different factors to determine if the dividend is sustainable or not. Here are some of the most important things you will have to consider:
How old is the company?
Old and mature companies will tend to have stable revenues and earnings. They are what is commonly described as cash cows. These companies usually tend to return a high percentage of their earnings to shareholders through dividends.
How stable are the company’s earnings and revenues?
One of the most important factors to consider is whether or not the company’s earnings and revenues are stable. A company with stable or even growing earnings and revenues will be able to have a higher payout ratio because it is expected that as earnings grow, the payout ratio will be lower over time if the dividend is kept.
Is the company still growing?
If a company is still growing, the payout ratio can generally be higher. In theory, since the earnings are increasing over time, the payout ratio will be lower. Therefore, you can consider investing in stocks with higher payout ratios as long as the company is still growing.
Does the company increase its dividend regularly?
Dividend aristocrat stocks are constantly increasing their dividend, and while it can be debated whether this is good or bad, it does affect how you analyze the payout ratio. A dividend growth stock will increase its dividend regularly, and this means that unless the company can grow its earnings, the payout ratio will increase over time.
Therefore, when investing in this type of stock, you want to ensure plenty of room for the company to grow. Since the board and management are often pressured to increase the dividend, this may affect the payout ratio.
Additionally, this type of stock usually has a shareholder base that puts a lot of emphasis on dividends, and if the dividend does not increase, the stock price may come down. Additionally, if by any chance the company has to halt the dividend, then the stock price will tumble, as income-focused investors will dump the stock.
What industry is the company in?
The industry and sector the company is in also affect how you should analyze the payout ratio and determine what is a good payout ratio. Industries that are constantly evolving and changing, like tech, for example, will require additional CAPEX and R&D, and for these reasons, you want to invest in tech stocks with a low payout ratio.
This ensures the company has enough capital to invest in its operations, and its cash flow and earnings are not pressured by the regular dividend. For companies in well-developed and mature industries, the payout ratio can be higher because the need for constant investment is not as high to stay competitive among its peers.
Is the company actively investing in growing?
While dividends may be an essential component of investing, the company cannot stop investing in itself. A high payout ratio could possibly mean that the company is not using enough capital to grow continuously, and this can be a sign of revenue and earnings stagnation that could also affect the stock price over the long term.
Compare the payout ratio of competitors
Another way to be able to determine what a good payout ratio is by comparing it with the other competitors. While this is not a sure way to determine whether or not the payout ratio is good, it will help you to understand how the industry works.
If the stock you are considering has a high dividend yield and a high dividend payout while the competitors have low payout ratios and are using their capital to invest in the business, this can be a red flag. While returning capital to shareholders is important and should be valued, you want to avoid stocks of companies that fail to reinvest and grow organically.
This means that over time they might return a lot of money in the form of dividends but at the expense of becoming uncompetitive and losing market share to their counterparts actively investing in their businesses, expanding and growing.
Should you invest in stocks with a high or low dividend payout ratio?
While there is no rule of thumb, it is usually better to focus on stocks that have a low payout ratio. This means the dividend is more likely to be sustainable, and the company has room to increase it.
Companies with a lower payout ratio are also less enticed to maintain or increase dividends to please the shareholders looking for this type of return. You should also be aware that companies with a high dividend yield and a high payout ratio are, most of the time, risky investments that may not be worth looking into.
Additionally, you should avoid at all costs stocks with a payout ratio above 100% because this means that the company is using its cash reserves or borrowing money to return it to shareholders; thus, the dividend is unsustainable. While for some companies, this may happen during one or two quarters, other companies can have payout ratios above 100% for a few years, which in investing is generally a huge red flag.
What is a good payout ratio?
A good payout ratio for companies still growing in fast-moving industries is usually under 30%. This gives the company enough capital to reinvest in the business, make acquisitions, and continuously expand its market share. For companies that are well-established and have been paying dividends for a long time, a good dividend payout ratio under 50% is often advisable. These companies do not require as much investment to remain competitive, and therefore they can use a good chunk of their earnings to distribute among shareholders.
The payout ratio is one of the most important financial ratios to consider when analyzing a stock that pays a dividend. First, you want to make sure the dividend is sustainable, and the company will not cut it abruptly because this can put a lot of selling pressure on the stock. You also want to ensure that if the company has a bad quarter, it will still be able to keep the dividend without borrowing money to return it to shareholders.
While determining a good payout ratio is highly subjective and depends on different factors and the type of investor you are, you should always compare the payout ratio of a stock with its competitors and industry peers. This will allow you to have a better idea of what the average payout ratio is and whether or not the stock is in line with that.
Dividend payout ratio FAQ
Is a low dividend payout good?
Broadly speaking, a low dividend payout ratio is usually a good sign that the company is generating plenty of profits to be and is using that capital to invest in itself while also rewarding shareholders. Stocks with low dividend payout ratios also have sustainable dividends, giving the company room to increase its dividend or even pay a special dividend from time to time.
What does a high dividend payout ratio mean?
A high dividend payout ratio means that the company is using a large percentage of its earnings to pay shareholders a dividend, which is usually a risk to the sustainability of the dividend over time. It also puts additional pressure on the stock price since most of the earnings the business generates are distributed. Therefore the value of the business is not as likely to increase over time.
A high payout ratio also can indicate that the company is unable to invest its capital to grow further, and this is usually a sign that the stock may not increase a lot in the coming years, and revenues and earnings might be stable for a long time.
What does a low dividend payout ratio mean?
A low dividend payout ratio means that the company only pays a small percentage of its earnings in the form of dividends, which signals that the dividend is sustainable and the company can even increase it. It also means that the company can remain more competitive because it can use part of its earnings to invest in the business.
What if the dividend payout ratio is more than 100?
Stocks with a payout ratio of over 100% are often seen as extremely risky because the company is not generating enough earnings to pay its dividends, and when the dividend is halted or cut, the stock price will decline as a reflection of that. Generally speaking, some stocks might have a payout ratio over 100% due to one or two bad quarters. Still, if the situation persists for over a year, it is usually better to stay away from this type of company. They are either using their cash reserves to pay dividends or borrowing money, or selling assets to maintain their dividend, which in the long run, destroys shareholder value.
Do investors want a higher or lower payout ratio?
Typically investors looking to generate income from their stock portfolio prefer higher payout ratios, which means the company will distribute a higher percentage of its earnings in the form of dividends. However, investors that prefer growth stocks, might look at lower payout ratios as an indication that the business will be reinvesting their money instead of distributing it to shareholders.