Payout Ratio: Explained
As a shareholder, ever wonder how much of the company’s income returns to you? The payout ratio shows precisely that. Investors use this measure when making investment decisions.
What Is The Payout Ratio?
The payout ratio shows the percentage of a company’s earnings paid out as dividends.
Payout Ratio = (Dividends / Net Income) * 100
Payout Ratio = (Dividend per share / Earnings per share) * 100
Additionally, dividends are an integral part of corporate policy. After all, dividends are the only non-speculative way to earn return in the stock market. Surely, investors sell stock higher than they purchased for a profit, but this is capital appreciation, and much more unpredictable than dividends.
Analyzing The Payout Ratio
Why does this matter to investors? Dividends are not guaranteed by management. Once management declares a dividend, they usually uphold the policy as a sign of strength. However, in dire circumstances, companies either reduce the dividend or stop it altogether.
For this reason, investors use this measure for clarity. A low payout ratio indicates that companies keep more of their earnings in order to fuel growth. Conversely, companies with a higher ratio have no better use of their cash. Savvy investors have opinions on how much retained earnings the company needs going forward. For example, a growing company that burns cash quickly with a high payout ratio might not be sustainable. For this reason, investors forgo the investment, or even bet against the company.
Also, what ratio is best for companies? It is certainly a matter of investor preference. An investors who relies on dividends as income looks for a lower to medium ratio. This is because the company is likely to increase or maintain the current payout ratio. Conversely, older companies with higher payout ratios cut dividends if earnings decrease.
The payout ratio paints of a picture of how a company uses its net income. Also, payout ratio trends gauge the overall health of the company as a whole. This ratio is valued by speculative investors and long-term investors alike.