What is the dividend payout ratio? Definition and example
The dividend payout ratio is the fraction a business pays out to its stockholders in dividends from net profits, i.e. the percentage of net earnings paid out in dividends to shareholders.
Dividend Payout Ratio = Dividends ÷ Net Income.
In the UK, a measure called dividend cover is more common, which is calculated by dividing earnings per share by dividends per share.
The amount that is not paid out in dividends, known as retained earnings, is held by the business for expansion.
Whether to invest in money today or jam tomorrow
The dividend payout ratio is used by investors when deciding whether to invest in a profitable firm that pays out good dividends, or a profitable business that has promising growth potential.
The majority of start-up companies and many tech firms rarely give out any dividends. The American multinational technology giant, Apple Inc., which was formed in the 1970s, did not give out any dividends to stockholders until 2012.
Some companies, on the other hand, are so eager to attract investors that they pay out unreasonably high dividend percentages. This approach is unsustainable, because eventually money will be needed for their operations.
Most investors seek a consistent trend in the dividend payout ratio, rather than sudden high or low ratios.
Example of a dividend payout ratio
Fictitious company John Doe Inc. reported a net income of $500,000 on its income statement for 2015. During that year the company issued $125,000 in dividends to its stockholders.
John Doe’s dividend payout ratio is:
(dividends) 125,000 ÷ (net income) 500,000 = a dividend payout ratio of 0.25 or 25%.
The proportion of net income that the company keeps is called the retention ratio. Therefore, John Doe’s retention ratio for 2015 was 0.75 or 75%.