The dividend payout ratio allows investors to analyse the percentage of profits paid as dividends to shareholders. It can provide valuable insight into dividends’ sustainability and future growth potential. After all, these are optional payments which can be cut, suspended, or even outright cancelled if a company needs to retain its capital.

Needless to say, income investors are rarely interested in firms that don’t have the financial strength and cash flow to maintain dividends.

What is the dividend payout ratio?

Dividend payout ratios compare the total amount of dividends paid against the earnings of a specific period. The proportion of retained earnings for internal use is called the retention ratio. Both are expressed as a percentage between 0% and 100%. However, it’s possible to exceed these limits in certain situations.

Let’s look at a quick example. ABC Group has just released its full-year results whereby £50m were redistributed to shareholders via a cash dividend. In the same year, the company reported a net income of £250m. Therefore, its dividend payout ratio stands at 20%, while the retention ratio is 80%,

What does the dividend payout ratio tell investors?

This financial ratio can inform an investor on several matters, including future growth potential as well as risk. And using this interpretation, they can make a more informed investment decision relating to their personal investment goals and risk tolerance.

Every company and industry is different, each capable of sustainably maintaining different levels of the payout ratio. But as a general rule of thumb, if the balance is:

• > 100% – This means the business is distributing more in dividends than is being produced in earnings. In most cases, this is a giant red flag. Firms cannot sustainably redistribute more profits than they’re creating. As such, the probability of a dividend cut is exceptionally high, likely followed by a sharp drop in share price.
• > 65% – In this situation, the bulk of earnings are redistributed, providing a lucrative stream of passive income. However, innovating new products or services could be challenging, with only small sums of retained earnings. As such, the company may struggle to increase its dividends further in the future.
• < 30% – A low payout ratio indicates a company keeps most earnings for internal investments. This is more common among growth stocks. But income stocks with low shareholder payouts can exhibit potential future dividend growth given the extra capacity.

What is a good payout ratio?

As previously mentioned, what qualifies as a good payout ratio is ultimately company-specific. Businesses must balance the return on shareholder capital with internal investment to ensure innovation and expansion don’t suffer.

When analysing this financial metric, investors must consider the following:

• Company’s Age – A young enterprise still in the growth stage of the business cycle should be retaining as much capital as possible. While uncommon, seeing a young business with a high payout ratio can be concerning. Similarly, suppose a company has already reached maturity and is struggling to deliver any meaningful growth. In that case, a low payout ratio could be a bad sign as it may indicate management can’t allocate capital effectively.
• Financial Performance – A company struggling financially may have a lower payout ratio than companies performing well for obvious reasons. Stagnancy in financial performance can also affect the company’s ratio over time.  
• Balance Sheet Strength – A highly indebted company may only be able to sustain a low payout ratio because interest expenses on debt will gobble up more of its capital. However, firms with little-to-no leverage have more cash flow available to redistribute as dividends.
• Payout Ratio History – A business that has historically maintained a consistent target payout ratio may indicate talented leadership capable of prudent financial planning. However, it’s important to remember that dividends can still be adversely affected in the future.

Limitations

As popular and powerful as this financial metric can be, it has a design flaw: using net income. Why? Because reported net income also includes charges or gains that are non-cash, meaning they don’t affect cash flow. Some common examples would be depreciation & amortisation or a revaluation of real estate assets.

For example, let’s say £180m of ABC Group’s £250m reported net income came from a significant increase in the value of a piece of real estate it owns. This increase in valuation is reported as a gain on the income statement, even though the asset hasn’t been sold. And consequently, its earnings figure is inflated significantly above the profits generated from actual operations.

Therefore, an investor may be misled into thinking the £50m dividend equates to a 20% payout ratio when it’s actually closer to 70%. And that doesn’t include any clever accounting tricks a management team can use to further inflate its financials.

To overcome the problem of non-cash items affecting net income, investors can use a modified version of the dividend payout ratio that relies on Free Cash Flow To Equity (FCFE).

The FCFE represents the excess cash flow a company generates from operations after all other internal investments and obligations have been settled, including to debt holders. It effectively defines the amount of capital a company has the capacity to redistribute as dividends.

What is the difference between a company payout ratio and yield?

Another popular metric used by income investors is the dividend yield. It represents the number of dividends paid per share as a proportion of the stock price. And it can provide a theoretical indicator for the return on investment a position will generate in one year, excluding the effects of any share price gains or declines.

While both the dividend yield and dividend payout ratio are percentage metrics, they provide fundamentally different pieces of information. The payout ratio indicates a company’s ability to pay a dividend, while the yield offers insight into the level of income return an investor can expect to receive.

The bottom line

The dividend payout ratio isn’t as popular as a dividend yield. But it’s arguably more informative, providing a clear picture of the sustainability of a firm’s shareholder payouts. What’s considered a good or bad value depends on the circumstances surrounding the company in question. And investors need to evaluate these circumstances when interpreting this metric.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.