Payout Ratio

What is the Payout Ratio?

The payout ratio expresses the percentage of a company’s earnings that is paid out to its shareholders in the form of dividend payments. The payout ratio is sometimes referred to as the dividend payout ratio.

Payout Ratio Formula

The payout ratio is calculated as:

Payout Ratio = Total dividends / Net income

or

Payout Ratio = Total dividends per share/Earnings per share

Shareholders may be entitled to dividends if agreed by the board of directors. Dividends are a cash payment for each share owned as a form of return to shareholders. Net income is the profit attributable to common shareholders after all expenses have been deducted for the period. We use this profit figure as this is the profit available to shareholders. If the company reported a loss, the payout ratio would equal zero as there is no available cash to pay the owners.

Payout Ratio and Cash Flows

While the payout ratio formula uses net income in the denominator, the ratio is closely linked to a company’s cash flows. Investors need to keep in mind that net income does not necessarily equate to cash flow. A company can report high earnings but have no cash to make dividend payments.

We can understand the link between the payout ratio and cash flows by looking at a company’s cash flow statement. There are three parts to any company’s cash flow statement:

1) Cash flow from operations

2) Cash flow from investing activities

3) Cash flow from financing activities.

Strong, positive cash flow from operations is the starting point of any decisions relating to dividends. Subsequently, such decisions are reflected in the other two parts of cash flow statements.

Cash Flow from Investing Activities:

The company can also invest the amount in long-term assets that could grow a company’s revenues in the future. Items reported under cash flow from investing activities include purchases of long-term assets such as property, plant and equipment (PP&E), investments in marketable securities such as stocks and bonds, as well as acquisitions of other businesses.

Finally, the company can choose to set aside some surplus cash as cash reserves. Companies like Microsoft, Apple, Berkshire Hathaway, and Alphabet maintain huge cash reserves on their balance sheets.

Cash Flow from Financing Activities:

When companies pay cash dividends, they treat it as a cash outflow and record the impact in this section of the cash flow statement. Alternatively, the company could also use the surplus cash towards other financing activities such as repayment of debt to save on future interest expenses. It can also use cash for share buybacks.

Calculating the Payout Ratio

Example 1:

Here is some information about a company’s earnings and its dividends.

Using the information above, we calculate the payout ratio for this business as 50%. The company has paid 50% of its earnings as dividends and has retained the remaining 50%.

Example 2:

In another scenario, we have the following information:

The payout ratio for this company is 37.5%. It has retained the remaining 62.5%. It can use the amount retained in any of the ways listed above.

Analyzing the Payout Ratio

Low payout ratio

A low payout ratio indicates a company is repatriating a low share of its net income to common shareholders. It is likely that the company is reinvesting its profits back into the business. As a result, the company is likely to generate higher returns for shareholders in the future. A company could also be generating low income relative to the percentage of dividends paid out.  Shareholders investing in these types of businesses are looking for capital appreciation on their shares rather than income from dividends.

High payout ratio

A high payout ratio indicates that the company is paying out a large share of its net income to common shareholders in the form of dividend payments. The company may not have any potential opportunities for reinvestment and thus is repatriating cash back to investors. Certain industries, such as the REIT industry, are required by law to maintain a high payout ratio. In some cases, companies may have a payout ratio above 100%. However, over the long term, a payout ratio of above 100% is unsustainable. Investors looking at regular income prefer stocks with high payout ratios.

Variability by industry

The payout ratio varies depending on the industry. For example, defensive industries, such as pharmaceuticals and telecommunications, are less vulnerable to economic fluctuations or market downturns. Companies in such industries generate stable cash flows and earnings even during difficult economic times. Such companies tend to maintain stable payout ratios.

Conversely, cyclical industries, such as entertainment and luxury goods, depend highly on economic cycles. During tough economic times, consumers reduce their spending on luxury. Such companies deliver high earnings during periods of growth and low earnings during recessions. Consequently, such companies tend to have less reliable payout ratios. Also, industries such as the tech industry tend to pay low dividends, as the profits are reinvested in research and development.

Variability by company lifecycle

The payout ratio also varies depending on what stage a company is in its lifecycle. A start-up early in its lifecycle stage will typically generate low revenues and incurs high expenses. At this stage, a company has negative cash flow from operations, which are most likely compensated by positive cash flows from financing. In the growth stage, a company may start seeing growth in cash flow from operations. This will be reflected by an increase in its payout ratio. When a company is mature, it can start to repatriate capital either by repaying debt, repurchasing equity, or paying dividends.

Conclusion

The payout ratio is a strong indicator of an organization’s capacity and strategy to pay dividends from the profit attributable to shareholders. The payout ratio is closely related to a company’s cash flows. High cash flows from operations can result in a high payout ratio depending on the company’s dividend policy and its stage in the company lifecycle.