The Dividend Payout Ratio explained.

The Dividend Payout Ratio (DPR) is a measure of the percentage of a company’s net income that is paid out to shareholders as dividends. When a company earns profits, it can either retain them to fund operations or distribute them among shareholders as dividends. The DPR is a crucial indicator of how much money a company pays out to investors, as this reduces the amount of cash it can use for expansion and growth.

Investors monitor the payout ratio, which is related to their investment style. Investors seeking regular income prefer companies with a higher payout ratio, as they receive more profits as dividends instead of the company retaining them. On the other hand, investors looking for growth opportunities prefer companies with a lower or no payout ratio, as the company can use the cash to fund its expansion.

The DPR helps investors determine which investment opportunity aligns best with their investment strategy and goals. Additionally, investors should be aware of the dividend yield when considering the payout ratio. A high DPR means the company distributes more profits to shareholders, but it reinvests less in the business. In contrast, a low DPR means that the company reinvests more profits back into the business, which may contribute to capital gains for shareholders instead of income.

Typically, the percentage of payout varies depending on where a company is in the business cycle. Early-stage or rapidly growing companies usually have a lower dividend payout ratio, while more stable and mature companies with slower growth tend to have a higher dividend payout ratio and less requirement to reinvest in growth. These companies tend to have attractive Dividend Yields.

Much like the altering of the Dividend Yield a company once committed to a payout ratio typically avoids cutting it back. Lowering the payout ratio is always negatively received by the market. Companies that are doing well, and growing will start with a smaller payout ratio to reward shareholders but ensure they don’t run dry of the capital they need to continue to grow.

The inverse of the Dividend Payout Ratio is the Retention Ratio. I am not writing a separate article on that. If the Dividend Payout Ratio is 75% then the Retention Ratio is 25%. It is just the difference between what is paid out and retained and is fairly simple to understand.

The payout ratio will vary across industries. Tech companies usually have no dividends paid out and other larger Bluechip companies will pay a lot more. REITs (Real Estate Investment Trusts) have higher distributions as they are required by law to pay out earnings from property.

What is the Dividend Payout formula?

• Dividend Payout = Dividends Per Share ÷ Earnings Per Share.

The Dividend Payout can also be worked out by using the total Dividends paid out and rather than using the Earnings Per Share you can use Net Income.

The DPR is 0% for companies that do not pay dividends and is 100% for companies that pay all net income out as dividends.

How to use the Payout ratio?

If you were an income-focused investor the payout ratio would be used to asses whether the Dividend Yield is sustainable over time. A company that pays out a high percentage of earnings has little cash to sustain itself should things get a little rocky. Sometimes a company can have a DPR above 100% meaning they have committed to a Dividend Distribution plan and perhaps the year’s earnings were not as strong. This dips into precious cash the company may need.

In the example below, let’s asses three companies and look at the DPR for each to determine which may be the better fit if we were looking for a stable source of income. Assuming they are past the growth cycle and entering into a maturing stage.

DPR	Company A	Company B	Company C
Dividend Per Share	$1.45	$0.78	$1.68
Earnings Per Share	$2.89	$3.90	$2.22
Payout %	50%	20%	75%

Company A $1.45 ÷ $2.89 = 0.50 x 100 = 50%

Company B $0.78 ÷ $390 = 0.20 x 100 = 20%

Company C $1.68 ÷ $2.22 = 0.75 x 100 = 75%

In this simplified example, we can see the Payout Ratios of each company and how much they are paying out and retaining. As an income-focused investor, it may not be the best option to invest in Company B as it seems to be retaining a lot more of its earnings for growth. On the other hand, Company C has a very high payout ratio which needs to be assessed for sustainability, while also ensuring sufficient earnings are being retained for operations.

Company A, on the other hand, looks like a great option as it has a reasonable payout ratio. It has the potential to retain earnings to fuel growth, which can lead to both dividends and capital gains.

A steadily rising ratio is usually the sign of a healthy, maturing business, but inconsistent movements especially large increases in the percentage change could mean the dividend is heading into unsustainable territory. Let’s look at the example of Company A to asses consistency.

Company A	2021	2022	2023
Dividend Per Share	$0.77	$1.08	$1.45
Earnings Per Share	$1.95	$2.54	$2.89
Dividend Payout	39%	42%	50%

If we lay out the Dividends and the Earnings Per Share of a business we can see a steady, consistent increase in the payout ratio. There is little volatility, and a positive upward trend, indicating this business as it is improving, is balancing what it pays out to shareholders and what it keeps to fund operations.

There is an opportunity cost to paying out high dividends as that money distributed to shareholders cannot be invested in another part of the business.

When assessing high payout ratios it can signal issues with the business trying to attract investors based on higher returns, it could also mean they have little use of working capital to continue to expand. Industry comparison is important, ensuring we compare companies in the same sector as well as similar stages in the business cycle.

Companies raise money from shareholders to fund their operations and expansion. When they generate profits, they may distribute earnings to shareholders either through dividends, or indirectly by the share price increasing from efficient management. In my opinion, companies that strike a balance between these two methods pay close attention to their payout ratio. They ensure they maintain adequate working capital with attention to capital allocation, have promising reinvestment prospects, and room for future growth, while also rewarding shareholders for their investment.

In Summary…

When focusing on growth and the expectation of long-term capital appreciation from an investment, I ultimately want no dividend and if one is declared, it to be very small perhaps less than 20%. If a dividend is paid out it is not simply about rewarding investors with their portion of the profits, it signals to me they are running out of reinvestment opportunities. High Returns on Invested Capital is what can compound capital and the share price.

If a company decides not to pay a dividend because they believe they can reinvest that cash to further grow profits then I am very happy with this. Now it all once again falls to your investment style, however, I would rather compound my capital tax-free for years with an efficiently operating company than be paid out those earnings each year. If income is the priority then of course you want a nice juicy Dividend payout ratio that is consistent and sustainable.

I much prefer to see companies in growth retain all the cash they make to fuel expansion, if they are profitable and don’t need to dilute shareholders or take on debt, then that is where the magic of compounders can begin.

If I come across a company that has strong prospects but a lot of debt and is paying out dividends, I usually skip researching that business altogether. This indicates that the company is not focusing enough attention on its financial health or long-term growth strategies. I often find this to be the case in the small-cap sector, where many management and inside ownership are more interested in getting dividends into their pockets rather than fueling the growth of the business or protecting against potential downsides. Whilst it can appear on the surface to be “shareholder aligned” the business health and longevity comes above all else.