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Dividend Payout Ratio

Understand the Dividend Payout Ratio

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Dividend Payout Ratio

In This Article
  • What is the formula used to calculate the dividend payout ratio?
  • How is the dividend payout ratio related to the retention ratio?
  • What is considered to be a “good” dividend payout ratio?
  • Which specific factors affect the retention ratio?

Dividend Payout Ratio Definition

Often referred to as the “payout ratio”, the dividend payout ratio is a metric used to measure the total amount of dividends paid to shareholders in relation to a company’s net earnings.

Simply put, the dividend payout ratio is the percentage of a company’s earnings that are issued to compensate shareholders in the form of dividends.

Generally speaking, earnings that are not paid out to common and/or preferred shareholders are kept by the company and are used for other spending requirements, which can include:

  • Repayment of Debt and Servicing of Interest Expense
  • Re-Investing in Core Operations (e.g. Hire More Employees)
  • Upgrading Internal Workflow and Software Systems (i.e. CRM, ERP)
  • Acquiring Companies (M&A)

As the inverse of the retention ratio (and the sum of the two ratios should always equal 100%), the payout ratio represents how much capital is returned to shareholders.

Since the management team made the discretionary decision to issue dividends to preferred and/or common shareholders, it can be inferred that the company has reached a steady-state in which profitability and cash flows are not a concern.

But from a more cynical perspective, the decision to issue dividends could also suggest that the number of projects that could be undertaken to increase growth is limited, which is why management decided it’d be best to simply compensate investors directly via dividends.

Dividend Payout Ratio Formula

To calculate the dividend payout ratio, the formula divides the dividend amount distributed in the period by the net income in the same period.

Formula
  • Dividend Payout Ratio = Dividends / Net Income

For example, if a company issued $20 million in dividends in the current period with $100 million in net income, the payout ratio would be 20%.

  • Payout Ratio = $20m ÷ $100m = 20%

To interpret the ratio we just calculated, the company made the decision to payout 20% of its net earnings to its shareholders via dividends.

On the opposite end, the company’s retention ratio is 80%.

  • Retention Ratio = 1 – 20% = 80%

Putting this all together, the company issues 20% of its net earnings to shareholders and retains the remaining 80% of its net income for re-investing needs.

Along the same lines, the formula could’ve also used dividends per share in the numerator and earnings per share in the denominator.

Formula
  • Payout Ratio = Dividends Per Share / EPS

If the same company issued annual dividends of $1.00 per share (DPS) with $5.00 in diluted EPS, the payout ratio also comes out to 20%

  • Payout Ratio = $1.00 DPS ÷ $5.00 EPS = 20%

In yet another alternative method, we can calculate the payout ratio as one minus the retention ratio.

In our example, the payout ratio as calculated under this 3rd approach is once again 20%.

  • Payout Ratio = 1 – 80% = 20%
Dividend Issuance 3-Statement Impact

A common accounting interview question is: “How are the three financial statements impacted if a company initiates a dividend?”

  • Income Statement (I/S): If a company has initiated a cash-funded dividend, there’ll be no immediate impact on the income statement. However, a section below the net income line item will state the dividend per share (“DPS”) attributable to common and preferred shareholders.
  • Cash Flow Statement (CFS): As for the statement of cash flows, the cash from financing section decreases by the dividend payout amount, which lowers the ending cash balance.
  • Balance Sheet (B/S): On the assets side of the balance sheet, the cash account declines by the dividend amount issued, and the offsetting entry will be a decrease in retained earnings since dividends come directly out of a company’s retained earnings – which is how the balance sheet remains in balance.

Note that in the simple interview question above, we’re assuming that the funding for the dividend payout came from the cash reserves belonging to the company, rather than raising new debt financing to issue the dividend(s).

Risks to High Payout Ratios

Just as a generalization, the payout ratio tends to be higher for mature, low-growth companies with large cash balances that have accumulated after years of consistent performance.

Given the historical track record and steady market positioning – i.e. predictable profit margins, downside protection, and defensible market share in a mature industry – such companies can afford to issue dividends if management decides doing so would be most beneficial for their shareholder base.

But one concern regarding the introduction of corporate dividend issuance programs is that once implemented, dividends are rarely reduced (or discontinued).

Once announced, the type of investors purchasing these shares will shift towards risk-averse, long-term investors, as the risk profile of the company becomes more closely aligned with such investors’ investment criteria.

If a dividend program is halted (or even reduced), the market tends to be prone to overreact, as institutional and retail investors – who have access to less information than internal corporate decision-makers – will assume the worst.

Hence, public companies are typically very reluctant to adjust their dividend policy, which is one reason behind the increased prevalence of share buybacks.

AT&T 2021 Dividend Cut Example

Historically, companies in the telecommunication sector have been viewed as a “safe haven” for investors pursuing a reliable, dividend-based stream of income.

But as shown by AT&T Inc. (NYSE: T) in May 2021, approximately $16 billion in market capitalization was lost within a span of a week after AT&T signaled a potential dividend cut as part of an M&A deal with Discovery – which goes to show the extent that going against the main shareholder base’s expectations can be a very costly mistake (i.e. misalignment in corporate decisions and shareholder expectations).

AT&T

AT&T Market Value (Source: Bloomberg)

In addition, dividends are not tax-deductible and corporate earnings receive “double-taxation”:

  1. The first instance of taxation occurs when the company must pay taxes on its taxable income (EBT).
  2. The second instance of taxation takes place when shareholders receive the dividends and are required to pay personal income taxes on their capital gains.

Interpreting the Dividend Payout Ratio

  • Low Payout Ratio: Company is likely exhibiting high growth and reinvesting into its business, either as a defensive measure or to capture more market share from larger incumbents – in effect, the company is issuing fewer of its net earnings in the form of dividends, but increasing the likelihood of increasing its share price through other means (and causing capital gains for investors).
  • High Payout Ratio: Common for companies in the later stages of their life cycle – by issuing more dividends to shareholders instead of reinvesting into the growth of the company, the probability of capital gains for investors is reduced. However, this aligns with what many risk-averse investors seek (i.e. dividend income investors).

Companies with high growth and no dividend program tend to attract growth investors that actually prefer the company to continue re-investing at the expense of not receiving a steady source of income via dividends.

Instead, such investors seek to profit from share price appreciation, which is largely a function of revenue growth and margin expansion, among many important factors.

In the case of low-growth, dividend companies, investors typically seek some sort of assurance that there’ll be a steady stream of income rather than share price appreciation.

The takeaway is that the motivations behind an investor base of a company are largely based on risk tolerance and the preferred method of profit.

Target Ratio

An important aspect to be aware of is that comparisons of the payout ratio should be done among companies in the same (or similar) industry and at relatively identical stages in their life cycle.

There is no target payout ratio that all companies in all industries and of varying sizes aim for because the metric varies depending on the industry and the maturity of the company in question.

In short, there is far too much variability in the payout ratio based on the industry-specific considerations and lifecycle factors for there to be a so-called “ideal” DPR.

Dividend Payout Ratio — Excel Calculator

Now that we’ve explained the concept of the dividend payout ratio, we can move to an example modeling exercise.

For access to the Excel file, fill out the form below:

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Dividend Payout Ratio Example Calculation

For our modeling exercise, we’ll begin by listing out the initial model assumptions:

Year 0 Financials

  • Net Income = $200m
  • Dividends Distributed = $50m

The retained earnings equation consists of net income minus the dividends distributed, thereby the retained earnings for Year 0 is $150m.

  • Retained Earnings (Year 0) = $200m Net Income – $50m Dividends Distributed = $150m

Then, considering the payout ratio is equal to the dividends distributed divided by the net income, we get 25% as the payout ratio.

  • Payout Ratio (Year 0) = $50m Dividends Distributed ÷ 200m Net Income = 25%

DPS Excel Formula

For the entire forecast – from Year 1 to Year 4 – the payout ratio assumption of 25% will be extended across each year.

As a side calculation, we’ll also calculate the retention ratio, which is the retained earnings balance divided by net income.

  • Retention Ratio (Year 0) = $150m Retained Earnings ÷ $200m Net Income = 75%

To summarize, the 25% payout ratio indicates that 25% of the company’s net income is issued to equity shareholders, whereas 75% of the net earnings are kept each period (and rolled over and accumulated into the next period).

Forecasting the Payout Ratio

In the second part of our modeling exercise, we’ll project the company’s retained earnings using the 25% payout ratio assumption.

Forecast Assumptions

  • Dividend Payout Ratio: 25% Each Year
  • Net Income: $10m Decline Each Year

If applicable, throughout earnings calls and within financial reports, public companies often suggest or explicitly disclose their plans for upcoming dividend issuances.

The dividend issuance can come in several variations, but two common examples are:

  1. Dividend Issuance Program (i.e. Long-Term, Recurring Commitment)
  2. One-Time, “Special” Dividend

For purposes of projections, it is recommended to use the managed guided payout ratio, as it’d be rare for a management team to announce their earnings retention plan to shareholders (i.e. if no mention of dividends, it can be assumed the earnings will be retained).

The process of forecasting retained earnings for the next four years will require us to multiply the payout ratio assumption by the net income amount in the coinciding period.

Besides the dividend payout assumption, another assumption is that net income will experience negative growth and fall by $10m each year – starting at $200m in Year 0 to $170m in Year 4.

As a quick side remark, the inverse of the payout ratio is the retention ratio, which is why at the bottom we inserted a “Check” function to confirm that the two equal add up to 100% each year.

From Year 0 to Year 4, the retained earnings balance declines from $150m to $128m, which is attributable to the 25% payout ratio, which is on the higher end, especially considering that there is no growth in net income to offset the dividend issuances.

By itself, the payout ratio cannot definitively evaluate the financial health of a company, but it can give investors a general sense of what the company’s management team currently prioritizes and views as its prospects for future growth.

DPS Done

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