Dividend Payout Ratio
The dividend payout ratio is a popular tool used to evaluate the safety of a company’s dividend payouts. This ratio is used to measure the percentage of a company’s net income that is paid out to investors as dividends. The concept sounds simple, but as you will see, there are a few issues to consider after you have calculated this value.
The dividend payout ratio is calculated by dividing the dividend per share by the net income per share, and is usually then multiplied by 100 and represented as a percentage. An important detail to remember is to make sure the values you use in this calculation cover the same period of time. An example will help illustrate this:
In 2010, Abbott Labs (ABT) reported $2.99 in net income per share, and $1.76 in dividends paid per share. In this example, Abbott Labs had a dividend payout ratio = ($1.76/$2.99)*100% = 59%. Since Abbott Labs paid 59% of their earnings to investors in the form of cash dividends, that also means they kept 41% of their profits to help them grow their business.
So now that you know how to calculate the dividend payout ratio, how do you use it to determine whether or not a given level is good or bad for the high dividend stocks you are evaluating? Well, that all depends on the company you are evaluating, the industry it is in, and a number of other variables.
Let’s start with an obvious case, where the dividend payout ratio is greater than 100%. Yes, there really are stocks out there right now with dividend payout ratios of 100% or more. Obviously this is not a long-term sustainable condition. These companies are paying their dividends by drawing down their cash, selling assets, selling more stock (and dilluting the value of shares held by current investors), or even taking on debt. Sometimes this is a very temporary condition, when a company has fallen on hard times, or has experienced a single bad event, like losing a lawsuit. Other times, it is a continuing issue that will eventually resolve itself by cutting the dividend. Obviously, it is better for a company to have a dividend payout ratio below 100%.
To look at the opposite end of the spectrum, companies with very low dividend payout ratios are more likely to have a safe dividend, since they have a larger percentage of their profits available from which to maintain the current dividend payment levels. Also, if there is a low payout ratio, there is room to grow the dividend in the future.
For the vast majority of dividend paying stocks, the dividend payout ratio is well below 100%. It is best to review the ratio of the company you are thinking about buying against its historical ratio for the past few years. If the dividend payout ratio is increasing, you should do a little homework to figure out why.
You should also compare the dividend payout ratio of the stock you are checking out alongside other stocks that pay dividends in the same industry. Different industries have different average payout ratios. For instance, regulated utility companies have generally high dividend payout ratios, since their profits are relatively stable. If your company is too far above or below the average dividend payout ratio for the industry it is in, you should investigate why.
