What Exactly is Dividend Payout Ratio?

Introduction

Dividends are the most accessible way that regular investors can secure passive income.

These regular payments issued by a company to its shareholders are a direct signal that a company is financially healthy, and are by far the most direct way to provide value to shareholders.

And dividends shouldn’t be discounted—straight from the horse’s mouth, according to S&P Dow Jones Indices, dividends have contributed 32% of total returns when looking at data from 1926 to today. A third of all returns is a massive proportion—it’s clear that dividends can’t be ignored.

But the term passive income tends to fool investors—yes, although dividend payments are received passively, you’ll have to put in the legwork to identify good opportunities, and always stay vigilant in the landscape of ever-present market conditions.

In order to do that, you need to analyze. To analyze, you need tools—and concrete metrics, chief among them the dividend payout ratio (DPR), which will be your greatest source of information.

Dividends aren’t a one-trick pony—while the DPR will give you a wealth of information, it’s only one metric that should be analyzed before making a decision. Still, it is the most comprehensive metric of its kind—so there’s no better place to start.

Understanding Dividend Payout Ratio

The dividend payout ratio (DPR) is a financial metric used to gauge the financial health of a company by looking at how much of the company’s earnings are distributed to shareholders.

The DPR is given as a percentage—to use a simple example, a company that has $6 in earnings per share and pays out a $3 dividend has a DPR of 50%. In other words, 50% of earnings are given to shareholders, while the other half is retained by the company to invest in further growth or to finance operations.

By using the DPR, investors can get an immediate sense of how sustainable a company’s dividend is, as well as where the company’s earnings are going.

Of course, like any other metric, DPR can’t give us the full picture — but it is an integral piece of the puzzle when it comes to analyzing a company’s dividends, serving as a clear overview of the fraction of the profit paid out versus the amount retained to fuel future growth, innovation, and financial stability.

So, what’s the ideal DPR? The truth is that this varies quite a lot on a case-by-case basis. There’s no one-size-fits-all solution, and the best practice is to always compare the DPR of a stock to its competitors in the same industry.

You can find the average DPR of various industries here, courtesy of the NYU Stern School of Business.

Significance of Dividend Payout Ratio

The dividend payout ratio is an invaluable tool with a dual purpose—it tells us what proportion of earnings is being given to stockholders, while also giving us a clue about how sustainable a company’s current dividend policy is.

All in all, the main purpose of the DPR is to gauge the ability of a company to not only sustain, but even grow, its dividend payments.

Companies that have moderate dividend payout ratios are taken to be stable—their dividends are reliable, as enough of the company’s earnings are retained to finance operations, expand, or simply stay competitive. A moderate payout ratio is a sign that a company is confident that its earnings will remain stable—particularly if the company’s DPR has been stable for a long time.

High payout ratios, while attractive, tend to raise questions. If a company is giving, let’s say 85% of its earnings to shareholders, that leaves very little room to finance new growth—and very little in terms of a safety net should a downturn or recession occur. There is always the question of how sustainable high payout ratios are once you cross the 70% threshold.

As we’ll get into a little later, these aren’t universal truths—there are plenty of companies with high payout ratios that are stable and financially healthy, just as there are plenty of companies with low payout ratios that are in dire straits financially.

We would suggest looking at the DPR as an indicator of a company’s financial strategy, first and foremost. Low ratios suggest an intention to expand, fund R&D, or simply reduce debts to shore up the balance sheet—in essence, a low ratio is aimed at securing future growth, both in terms of stock price and future dividend payments.

On the other hand, a high ratio for a company in a stable, mature industry with limited room for growth is a signal that the company is committed to maximizing shareholder value, as keeping those earnings would do little to make the company grow or expand.

Whereas growth-focused investors will likely focus on companies with low DPR, investors focused on passive income usually look for companies with higher payout ratios.

Once all is said and done, it’s clear that the DPR is a useful metric that gives us a look “between the lines” of a balance sheet — let’s get into how to calculate the ratio, and then we’ll cover how to interpret it, what can have an effect on it, and what other metrics should be used in conjunction with the DPR.

How to Calculate Dividend Payout Ratio

One of the major advantages of this metric is that it is really easy to calculate. To find out a company’s dividend payout ratio, simply take the dividends per share (DPS) of the company, and divide it by the earnings per share (EPS).

Let’s start at the beginning—to find the DPS of a company, you have to look at the cash flow statement. Under dividends paid or dividends cash flow, you will see the total amount of money that a company pays out to shareholders.

Let’s review this through the example of Kimberly-Clark (NYSE: KMB):

Below we are displaying historical data using the Cash Flow View. The Dividends Cash Flow column is showing the cost of payments made by Kimberly-Clark to its common shareholders, preferred shareholders, and Noncontrolling interests.

Next, you’ll need to find the total number of outstanding shares. This can be found on the balance sheet or the quarterly/annual reports published by a company.

We can readily get this information from Stock Rover’s Insight Panel.

Once you have those two pieces of information, you can calculate DPS—simply divide the total dividends paid by the number of outstanding shares.

We have one piece of the equation now, in the form of the DPS—now, let’s take care of the other piece.

To calculate earnings per share, we need two data points—net income, and the number of outstanding shares.

Below we are displaying historical data using the Income Statement View.

Net income is found on balance sheets and quarterly and annual reports. Once you find it, divide net income by the number of outstanding shares—and now you have a company’s EPS.

Divide the DPS by the EPS, and voila, you have the dividend payout ratio.

Of course, there’s no real reason to do this manually—EPS is always included in quarterly reports and income statements. Below we see details for Kimberly-Clark (NYSE: KMB) using Stock Rover’s EPS Visual.

However, knowing how the mathematics behind this metric work is valuable knowledge, as it helps investors understand how various financial elements relate to one another.

Interpretation of Dividend Payout Ratio

High dividend payout ratios (above 60%) are enticing when it comes to securing passive income—but you need to dig deeper to find a company that can reliably pay out that proportion of dividends.

If you see a high dividend payout ratio in a well-established company that has a predictable profit stream, you might have an opportunity on your hands. Two great examples here are utilities and companies that produce consumer staples—as these sectors benefit from stable demand while also having limited room to grow.

On the other hand, if a company has an extremely high DPR (think 85% or more), this is usually a cause for concern. Even if the cash flows are stable, this leaves very little room in case of a downturn or recession, which could quickly make the dividend unsustainable. Such a high DPR can also signal a lack that there isn’t much growth potential in the future. While the lack of growth potential is fine for some industries like the aforementioned utilities and consumer staples, this is a bad sign for companies in most sectors.

At the other end of the spectrum, low payout ratios (generally below 40%) mean that a company is currently focusing on reinvesting earnings into the business to secure future growth. For example, tech companies are notorious for having low payout ratios, since the competitive tech landscape demands growth and innovation constantly.

In tandem with this, lower payout ratios are easier to sustain, and there’s a greater chance that the dividends will increase going forward with a company that exhibits a lower DPR.

If you’re interested in investing in dividends, using a watchlist or dividend tracker is a great way to cut through the chaff and get straight to the point.

In the image below, you can see StockRover’s watchlist feature. We are using the Table to compare 2023 dividend aristocrats. Dividend aristocrats are stocks that have increased dividends for the past 25 years consecutively—the best of the best. Focusing on lists like these is the best way to cut down on research time.

For example, one member of the dividend aristocrats list is NextEra Energy (NYSE: NEE). As an energy company, consistent demand allowed the business to keep raising dividends even in times of uncertainty. The Dividend Visual below shows the company currently maintains an attractive 48.2% dividend payout ratio.

Finally, the DPR is sometimes simply a reflection of a company’s current stage in its life cycle. A recently established company has to reinvest profits to fuel growth, while an industry leader that’s been in business for decades can afford to focus on returning value to shareholders directly.

Factors Influencing Dividend Payout Ratio

Everything in the stock market is in a constant state of motion—and that applies to dividend payment ratios as well. They aren’t set in stone—this figure is constantly changing and is affected by a wide variety of factors.

Understanding those factors allows investors to better gauge how the situation can change, allowing for a more robust and adaptable dividend strategy.

Since the DPR is based on earnings, fluctuating market conditions invariably have an effect on the DPR. A company that holds its dividend steady, but increases earnings would see a reduction in dividend payment ratio—likewise, a company maintaining a dividend would see an increased DPR if earnings were to fall. In tandem with that, a healthy cash flow is required to be able to pay out dividends consistently—since profits can also be in the form of non-liquid assets, just looking at earnings won’t be enough to perform a proper analysis.

As we can gather from what was just said, dividend policy plays an enormous role in a company’s DPR. If a company’s board decides that dividends are too high and that the business should focus on expansion, the dividend payments and the DPR will fall. Conversely, a company’s board can vote to increase the dividend in order to return value to shareholders, signal financial health, and attract new investors looking for passive income.

A company’s debt also plays a role in influencing DPR. High-interest debt can go a long way in reducing earnings, as companies usually prioritize debt repayments in order to avoid further costs and maintain their credit ratings.

Lastly, the past matters—companies that have a history of paying out reliable dividends, like the members of the Dividend Aristocrats list, face expectations from shareholders that this trend will continue.

Example of Divided Payout Ratio

Let’s walk through an example to illustrate how the dividend payout ratio works in practice.

• Net Income for the Year: $50 million
• Total Dividends Paid for the Year: $10 million
• Number of Outstanding Shares: 20 million

Step-by-Step Calculation:

• Determine Dividends Per Share (DPS):
  • Total Dividends Paid: $10 million
  • Number of Outstanding Shares: 20 million
  • Calculation: $10 million / 20 million shares = $0.50 per share
• Determine Earnings Per Share (EPS):
  • Net Income: $50 million
  • Number of Outstanding Shares: 20 million
  • EPS Calculation: $50 million / 20 million shares = $2.50 per share
• Calculate the Dividend Payout Ratio
  • DPS: $0.50
  • EPS: $2.50
  • Dividend Payout Ratio Calculation: $0.50 / $2.50 = 0.20 or 20%

Dividend Payout Ratio and Industry Norms

One of the easiest questions to pose in all of this is “What is a good dividend payout ratio?”. Well, like with most things, you won’t get an easy, straightforward, one-size-fits-all answer—but that question is answerable.

Here’s the rub—there’s no baseline that could serve as an average or a good measuring stick. Instead, what you want to do is look at a company’s peers and competitors when evaluating it—by which we mean, you should look at other companies in the industry or sector.

The reasoning is simple—with so many areas of human economic activity reflected in the stock market, it’s impossible to find an “average dividend payout ratio” that would be sensible for all industries. The business models are simply far too different.

Let’s use a couple of examples. Utilities, for example, have steady cash flows, constant demand for their services, and little room for growth or competition. Those factors lead to the fact that utilities, on average, have high dividend payout ratios—with the average for the sector being somewhere around 67%, per Morningstar’s research. The same holds true for telecommunication companies.

Consumer staples benefit from many of the same factors as utilities, with average dividend payout ratios ranging from 50% to 70%. These stocks are also a great hedge against inflation since consumer staples are a non-negotiable expense.

In the example below, The vs Industry Visual is showing that Procter & Gamble’s (NYSE: PG) 58.5% dividend payout ratio might be much higher than the average of the S&P 500 but is perfectly in line with the industry average.

The same goes for real estate investment trusts (REITs), which are even required by law to pay out 90% of taxable income to shareholders in the form of dividends.

Now for the other end of the spectrum. In general, anything that could be categorized as a growth stock will most likely have small dividends, or even no dividends at all. The reasoning is simple—in these competitive, cutting-edge industries, growth is everything—so every dollar has to be directed back to the company to expand the business, pay for R&D, and stay on top of the competition.

This is generally the case with growth stocks—but you’ll find most of these in industries and sectors such as tech and biotech. Even stable, mature companies in these sectors, like Google, sometimes don’t pay dividends at all.

Remember—always compare metrics such as these to other companies in the industry. Whereas a 70% dividend payout ratio wouldn’t be out of place for a utility, it would indeed be very troubling for a tech company, as it would signal a lack of growth opportunities.

Payout Ratio vs. Dividend Yield

Metrics should never be looked at in isolation. While useful, any single metric will only give an investor a piece of the puzzle.

When it comes to dividends, the payout ratio isn’t the only metric that needs to be considered—the other factor that needs to be taken into consideration is the dividend yield. Let’s go through the formula for calculating dividend yield, what it can tell us, and how it differs from and is similar to the dividend payout ratio.

The dividend payout ratio is a measure of how much of a company’s earnings are paid out via dividends. The dividend yield, however, is a measure of how much a company pays out to shareholders via dividends—but compared to the current stock price in question.

Whereas the dividend payout ratio gives us a glimpse at how sustainable a company’s dividend policy is, and how much money the company is choosing to keep in order to reinvest in expanding its business, the dividend yield is an immediate look into the return on investment of a dividend-paying stock.

In the image above, courtesy of StockRover’s Insight Panel, you can see the dividend yield of Dover Corp (NYSE: DOV). At 1.4%, it is just slightly higher than the average of the S&P 500.

However, as we’ve discussed, the average of the S&P 500 really isn’t a useful benchmark when evaluating dividends. On the other hand, the fact that the company’s yield is almost twice as high as the industry standard (1.4% vs 0.7%) tells us that this is potentially a good investment.

When we look at the payout ratio, we can see that it is 3.6% percentage points lower than the industry average. This is both sustainable and leaves room for growth—so all in all, DOV could be a good choice for investing in dividends.

Investors should always take both metrics into account when making a decision. For example, while a high dividend yield can be attractive if it is coupled with a high dividend payout ratio, the current rate of return that you can expect from the stock probably isn’t sustainable.

On the other hand, if you’re evaluating two that have similar payout ratios, the stock with the better dividend yield is likely the more attractive choice.

So, how is the dividend yield calculated? It’s quite simple—just take the annual dividend and divide it by the current stock price. In the example above, we would take $2.04 and divide it by $146.42, with the result being 1.4%.

Limitations of Dividend Payout Ratio

Alright—now that we’ve covered everything there is to know about the dividend payout ratio, only one key thing remains, and that is to cover the limits of this useful metric.

Before we begin, a small note—none of the things we’re going to mention here “debunk” or make the DPR less useful. Think of these more like additional factors that should be taken into account when using this metric to achieve the best results.

For one, the DPR relies on a company’s earnings, and although it might not seem like it at first glance, even earnings don’t tell the entire picture.

To use a couple of examples, a company’s earnings can be greatly affected by one-time events such as restructuring, legal fees, or asset sales. On top of that, different account methods (like inventory accounting and revenue recognition) that fall under GAAP can lead to different results when calculating revenue.

Next, some businesses are cyclical by nature. Industries like construction or automobile manufacturing experiencing severe fluctuations in earnings is completely normal, and shouldn’t cause doubts regarding the dividend sustainability of companies like those.

In order to counteract these factors, we would suggest that you use normalized earnings when calculating the dividend payout ratio of a company.

Moving on, the dividend payout ratio on its own, while useful, tells us nothing of the actual growth prospects of a company. A low payout ratio isn’t automatically a bad sign—it could just mean that the company is reinvesting the money into growth and that large, stable dividends or capital appreciation will follow afterward.

Finally, we would suggest always using cash flow analysis in tandem with earnings and dividend metrics to ascertain the real financial health of a business, together with other metrics such as return on equity (ROE) and return on assets (ROA).

Conclusion

The dividend payout ratio is an essential tool for investors looking to capture the long-term growth provided by dividends, or simply looking to acquire some convenient passive income. However, like every tool, you have to know how to use this metric in the proper way.

By using DPR in conjunction with other metrics such as dividend yield, and always contrasting the performance of stocks with other companies in the same industry, you can get a clear overview of how a business is doing. DPR isn’t a silver bullet—but it is an integral piece of the puzzle when it comes to deciphering the question of what to invest in.