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If you’re considering making an investment in a company, the proportion of the business’s net income spent on dividends is likely to be one of the most crucial factors in your decision. As a result, you’ll need to have a solid understanding of the dividend payout ratio. Find out more with this comprehensive guide, starting with our dividend payout ratio definition.
Dividend payout ratio definition
The dividend payout ratio, sometimes referred to simply as the payout ratio, is a financial metric that helps you to understand the total amount of dividends paid to shareholders in relation to the company’s net income. In other words, it’s the percentage of the business’s earnings that are delivered to shareholders in the form of dividends. Generally speaking, money that isn’t paid out in dividends goes back into the company to either pay off debt or reinvest in core operations.
Understanding the dividend payout ratio formula
There is a simple dividend payout ratio formula that you can use to calculate the proportion of dividends paid out by a company. The formula is as follows:
It’s also worth noting that some people prefer to calculate the dividend payout ratio on a per-share basis. In this case, dividends per share are divided by earnings per share (net income minus preferred stock dividends, divided by the average amount of outstanding shares over a given period). This dividend payout ratio formula is as follows:
Let’s look at an example to see how the dividend payout ratio formula works in practice. Imagine that Company A reported a net income of $550,000 for the year. Across the same period, Company A issued $150,000 in dividends. Therefore, we can calculate the dividend payout ratio like so:
So, 27% of Company A’s net income goes out to the shareholders in dividends, while the remaining 73% is reinvested in the company for growth.
What is the average dividend payout ratio?
The average dividend payout ratio is likely to vary dramatically depending on the priorities of the company. If they’re in a high-growth phase, for example, all profits are likely to be reinvested in the business, which means that the dividend payout ratio will be minimal. However, companies that aren’t focused on growth are likely to have much higher average dividend payout ratios.
Also, the average dividend payout ratio can vary significantly from one industry to another. For example, companies in the tech industry tend to have much lower payout ratios than utility companies. So, what counts as a “good” dividend payout ratio? Generally speaking, a dividend payout ratio of 30-50% is considered healthy, while anything over 50% could be unsustainable.
Interpretation of the dividend payout ratio
Investors use the dividend payout ratio to work out which businesses are best aligned with their goals. In most cases, firms with a high average dividend payout ratio are preferable for investors because they are likely to provide a steady stream of income. Furthermore, investors are likely to look at the trend in a company’s dividend payout ratio before deciding whether to invest. A downward trend of payouts may be a cause for concern, whereas a business that has consistently issued 20% of its profits to shareholders may be seen as a good bet for consistent and sustainable income.
Put simply, the dividend payout ratio can help you understand what type of returns a company is likely to offer and whether it’s a good fit for the investor’s portfolio.
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