Payout Ratio: Definition & Formula

What is Payout Ratio?

The payout (or dividend payout) ratio shows the proportion of earnings that the company pays to its shareholders in the form of dividends. It is expressed as a percentage of the company’s total earnings. Alternately, it may also be expressed as dividends paid out as a percentage of the company’s cash flow.

Calculating Payout Ratios

It is usually expressed as a percentage and is calculated as follows:

Payout Ratio = Dividends per Share (DPS ) / Earnings per Share (EPS)

If a company’s Earnings per Share came out to be of $15 and Dividends per share to be of $5, then its payout ratio would be 33%.

Understanding Payout Ratio

It is difficult to define an ideal payout ratio because this is largely dependent on the industry that the given company operates in. For example, companies operating in industries such as telecommunications and utilities tend to be able to support larger payout over a longer period of time whereas companies operating in cyclical industries such as travel and constructions have less reliable payouts due to their dependence on favorable macroeconomic factors.

Older companies are more likely to offer higher payouts as they are established and have the capacity to share more of their earnings with their shareholders. In comparison to this, newer companies will have lower payout ratios because they need to retain more of their earnings so that they may invest more in their business to ensure growth. However, companies with lower payout ratios have the potential to increase their dividend payment over time as this would be ensured by their business growth which they are working towards in the present.

It is important to note that if a company’s payout ratio is above 100%, it indicates that the company is paying more money to investors than it is taking in. This is an unrealistic approach and is not very sustainable as a result of this, dividend payments may go down over time. Companies with strong dividend payment record are more likely to have the stable payout ratios over time. Thus, from an investors point of view, the payout ratios can help determine whether or not the companies can maintain paying dividends to its shareholders in the long run.

This article was first appeared in our financial literacy blog: Sarmaaya.pk