What Does the Dividend Payout Ratio Mean?

The dividend payout ratio is an important financial metric that measures the percentage of profit a company distributes among its shareholders. As an investor, it helps you gauge how much profit a company is distributing to you as income and how much the company retains to support its growth.

This ratio is an evaluation metric for dividend-paying companies and helps estimate their income potential and stability.

As per the SEBI report, there are 13.6 crore stock market investors across India. Being one of them, and to make the most of the dividend benefits, read about it here in detail.

A Brief Understanding of Dividend Payout Ratio

A dividend payout ratio of a company essentially means a portion of a company’s net profits that it distributes to its shareholders as a dividend.

Companies represent this in the form of a percentage and signal how much of its profit a company returns to its investors and how much it keeps for debt repayments, reinvestment and other growth aspects.

If you see a dividend-paying company having a payout ratio higher than others, it signifies generous payouts. Conversely, a lower payout ratio of dividends highlights a more concentrated focus of a company towards increasing its financial strength and growth.

For a clearer understanding of it, let us resort to an example. Suppose you locate a dividend-paying company with a payout ratio of 40%. According to the basic payout ratio concept, it means that the company has channelled 40% of its net profit as earnings to its respective shareholders.

It retains the rest, i.e. 60% of its net profit for further obligations. They might include meeting its current debts, fueling developmental approaches like R&D, expansion and more. This portion of the net earnings is also referred to as retained earnings.

However, the dividend amount a company distributes per year varies from one year to the next. Therefore, as this amount changes, the payout ratio of a company also fluctuates.

How to Calculate Dividend Payout Ratio?

Now that you have an idea about what the dividend payout ratio, you must also note the process for calculating dividend payout ratio:

1. A Basic Calculation of the Dividend Payout Ratio

Suppose a dividend-paying company has recorded a net earnings of INR 500 crore. It paid INR 200 crore as dividend payouts for its shareholders. Here, you can calculate the payout ratio using the following formula:

Dividend Payout Ratio = (Total paid out dividends / Net Income) * 100 = (INR 200 crore / INR 500 crore) * 100 = 40%

2. Per-Share Calculation of Dividend Payout Ratio

Dividend per share, or DPS, is essentially the portion of profit a company makes and pays to its shareholders for each share they own. To calculate this, let us refer to another hypothetical scenario, where a smaller organisation pays out dividends, and its DPS is at INR 10. Its earnings per share are INR 30.

Now, let us place the above information in the following formula applicable for DPS:

Dividend Payout Ratio = (Dividend per share/earnings per share) * 100 = (INR 10 / INR 30) * 100 = 33.3%

3. Dividend Payout Ratio Based on Earnings Per Share

Being related to the ratio for dividend payouts, the Earnings per Share or EPS reveals the share of common shareholders on the net profit that a dividend-paying company has made. Referring to another example, suppose a company retains 60% of its earnings for its expansion across the country.

Here, the Dividend Payout Ratio = 100% – retention ratio = 100% – 60% = 40%.

Thus, the above payout figure as a payout ratio for the dividend helps you determine the profit-sharing approach of a company. It also gives you a sense of understanding of how it balances between rewarding shareholders and funding its plan for the long term.      

How Dividend Payout Ratio Differs from Dividend Yield?

Aside from the dividend payout ratio, there is another metric called dividend yield that helps evaluate the dividend-paying policies of a company. However, there are a few key distinguishing factors that you must note:

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How is the Dividend Ratio Interpreted for Different Industries?

Now that you have noted what is dividend payout ratio or DPR, how to calculate it and its differences from dividend yield, you must know how a DPR varies between industries. This might help with having a clearer idea about this dividend payout ratio:

Before choosing a company to invest in based on its dividend payout ratio, you must consider the sector or industry in which the company is operating. It is because, based on industries, DPR might vary between companies sharing a similar maturity level.

For example, an IT company that earns INR 1000 crore in profit might invest INR 750 crore in R&D and other aspects as they need continuous development to survive. This leaves 25%, i.e. INR 250 crore, to be shared as dividends.

Contrarily, suppose a mature utility company operating in the energy sector, with a similar maturity. It has a limited expansion need to earn INR 1000 crore. Here, the company might distribute INR 600 crore as dividends, making its dividend payout ratio of 60%.

What is Dividend Sustainability?

As the name suggests, it means how much potential a certain company has to make consistent dividend payments without leaving its financials or growth prospects unchecked.

Thus, with dividend sustainability, a company might be able to maintain an efficient dividend payout ratio even during market volatility or harsh economic conditions.

On the contrary, suppose a company increases its ratio from 30% to 80%. As an investor, this spike might seem attractive to you, but it raises additional concerns. One of the key concerns might be whether the company will be able to maintain such a high payout in the future.

Furthermore, as the company is paying out such a large amount from its profit, it might not be able to keep enough funds in reserve for its future growth. It might struggle to survive adverse economic conditions.

Key Benefits of Dividend Payout Ratio

Before investing based on this ratio, you must also consider its key benefits for an informed investment decision:

1. Consistency in Payouts

A consistent and efficient payout ratio for dividends generally indicates reliable dividend earnings with stability. It is helpful if you are seeking potential income from dividends.

2. Indicator of Financial Health

A high dividend payout ratio of a company typically signifies that the company boasts solid financial management and might have a strong cash flow.

3. Helps With Comparison

Using the dividend payout ratio helps you compare dividend policies of different companies operating in the same industry.

Limitations of Dividend Payout Ratio

Apart from its benefits for investments, you must also note some of its drawbacks:

1. Limitation in Cross-Industry Comparison

As you have seen, dividend payout varies between sectors, and therefore, a dividend payout ratio for a cross-industry evaluation might not be effective.

2. Might Mislead During Losses

Companies might keep making dividend payouts even during losses. In such a case, it renders the ratio to be distorted or have no meaning at all.

Factors affecting Dividend Payout Ratio

Here are some key factors that impact the dividend payout ratio that you must note:

1. Stable earning

Companies or businesses with stable or predictive earnings typically have a higher DPR. Conversely, a business with fluctuating earnings might reserve more profit and thus have a low DPR.

2. Profitability

A highly profitable company typically has the potential to pay higher dividends. It is because its higher profitability ensures that it does not need a significant reinvestment and maintains a higher amount as retained earnings.

3. Other Factors

Other factors include industry norms, the growth potential of a company in its industry, its debt level, tax considerations, etc.

Strategies to Manage Dividend Payout Ratio

To effectively manage the dividend payout ratio and to strike a balance between maintaining funds for growth and rewarding investors, companies employ the following strategies:

1. Maintains Dividend Policies

Companies typically try to gradually increase dividend payouts or at least maintain a stable payout to build investor confidence.

2. Ensures Cashflow

As a key strategy, companies typically first ensure that they have enough cash flow before declaring dividends.

3. Retain Profits

Companies also set aside a portion of their net profit strategically that aligns with their growth prospects.

Conclusion

The dividend payout ratio is a financial metric that shows how well a company maintains a balance between rewarding shareholders and retaining profits for its growth. They represent it in the form of a percentage and determine it using underlying formulas.

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FAQs on Dividend Payout Ratio

1. What is the formula for the dividend payout ratio?

The basic calculation requires the formula, i.e. total paid out dividends / net income * 100. However, there is a per-share calculation, which is Dividend per share/earnings per share * 100. For calculating DPR based on retention, use 100% minus the retention ratio.

2. What is a good payout ratio for dividends?

Generally, a dividend payout ratio between 30% and 50% is considered efficient.

3. Is a high dividend payout good?

If you are an income-focused investor, a high DPR might appear good. However, it also indicates that the company is left with a lower amount for reinvestment and growth.

4. What does a low Dividend Payout Ratio indicate?

A lower payout ratio indicates that a company might be retaining more for its growth, expansion and reinvestment and distributing the rest as a reward for investors.