Dividend Payout Ratio

The dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) in comparison to the company's net income; a company paying 20 million USD dividend out of their 100 million USD net income will have a ratio of 0.2.

It is an important indicator of how a company is doing financially. It is an important indicator of how a company is doing financially. However, as an investor, one needs to have a holistic view of the company instead of judging the company based on the dividend payout ratio.

A dividend payout ratio is a good indicator of how a company is doing in terms of its earnings, considering a few factors like volatility in the market, in which stage of the business cycle the company is in, the need for reinvestment because of expansion of the organization, how a company is being perceived in the stock market and so on. So as an investor, you need to have a holistic view of the company instead of judging the company based on the dividend payout ratio.

The primary motto of a company is to maximize the wealth So first, the company takes the money from the shareholders to finance its ongoing projects/operations. Then when these projects/operations make a profit, it becomes a duty and obligation for the company to share the profits with its shareholders. The amount of profit the company shares with the shareholders during a particular period is called a "dividend." And the percentage of the dividend that the company pays (out of the income they make) it's called the "dividend payout ratio."

There are different ways of calculating this ratio and according to the applicability, the formulas are different too.

Let us check out the formulas below:

Formula #1

First, we will discuss the most usual one and then explain the other two to expand on the concept.

Dividend Payout Ratio Formula = Dividends / Net Income

The dividend ratio is the percentage of net income paid to the shareholders as a dividend in simple terms.

To practically apply this ratio, you need to go to the company's income statement, look at the "net income," and find out if there are any "dividend payments."

Formula #2

Dividend Ratio = 1 – Retention Ratio

As mentioned above, the dividend is one portion of the profit. Another portion that the company keeps for reinvesting into the company's expansion is called retained earnings. And when we Calculate the percentage of retained earnings out of net income, we would get a retention ratio.

Retention Ratio = Retained Earnings / Net Income

So, in simple terms,

Dividend Payout Ratio Formula = 1 – (Retained Earnings / Net Income)

Or, Dividend Ratio = (Net Income – Retained Earnings)/Net Income

If you know the Net Income and Retained Earnings, you would easily be able to find out the dividend ratio of the company (if any). Just deduct the retained earnings from the net income and divide the figure by net income.

Formula #3

This formula is useful when you don't have immediate access to the income statement of the company, and you only have DPS and EPS. Simply divide DPS by EPS, and you would get the dividend ratio.

If you know the dividends and earnings, there is no way you should use this formula. But if you want to know the "per share" basis, here's what you should do. First, divide the dividend by the number of shares, getting DPS. Then divide the net income by the number of shares, and you would get EPS.

Most people use the first formula. But in cases where you can't access the income statement, alternative methods can be used.

Also, have a look at the Dividend Yield Ratio.

The dividend payout ratio, as obtained, can be used to evaluate multiple things and help organizations make effective business and financial decisions.Below is a list of things for which the interpretation of the ratio is required:

• The maturity of the Organization- First of all, by dividend payout ratio, one can understand the level of maturity. For example, if an organization is growth-oriented and new in the market, the chances are that most of the profits would reinvest into expanding its operations. Rarely do these new, growth-oriented companies pay dividends because to be able to pay dividends, they first need to go beyond their initial stage of business. Think of Amazon here.
• Reinvestment Opportunities - In some cases, established companies always don't pay a lot of dividends to the shareholders. In that case, it's a test of shareholders' patience as with time, they would expect more and more benefits to be returned to them. But many established companies justify their 0% payout ratio by reinvesting more and more money into the operation to ensure that the shareholders' money gets utilized properly and generates a better return for them shortly. Think of Berkshire Hathaway here.
• Maintaining Dividend Ratio Each Year - Other aspects of the dividend payout ratio should also be considered. If a company has started giving dividends for a few years, it should ensure that it gives away dividends every year without any downward trend. Maintenance of dividend payout every year helps the company do good in the stock market, and more and more investors get attracted to invest in the company. Think of Colgate here.
• Upward Trend in Dividends - Every company that pays a dividend should pay a higher dividend each year to the shareholders than the previous year. A long upward trend ensures that the company is financially healthy and doing great in generating revenue. A higher payout of dividends is not applicable for every company, but exceptions exist. For example, REITs (Real Estate Investment Trust) are legally obligated to pay 90% of their earnings to shareholders. In the case of MLPs (Master Limited Partnership), though not mandatory, the dividend payout ratio is usually higher.

According to the National Stock Exchange (NSE) report, this ratio varies from one industry to another with the electricity sector recording the lowest dividend payout ratio, while the manufacturing sector recording the highest value.

The determinants of the ratio include market-to-book ratio, business risk, debt-to-equity ratio, free cash flow, profitability, dividend distribution tax, etc. It has been observed that the firms with higher free cash flow, larger and mature structures and operations, and better profits pay more profit. On the other other hand, entities that offer high investment opportunities and reflect more risks pay lower dividends.

Let us consider the following examples to understand the concept and also check how it is calculated:

Example # 1

Let’s look at the Income Statement of ABC Company for the year 2015 and 2016 –

It is also reported that the dividend payment for the year 2016 was the US $50,000 and for the year 2015 was US $40,000.

Perform Dividend Ratio Analysis

First of all, there are two things to consider here.

First, dividend payment for the year would not come in the Income statement of the company. As dividend payment is not an expense, it should not reduce the earnings by any means.

Second, how much dividend was paid for the year would be taken into account in the financing section of the cash flow statement. So if you want to find the ratio in the usual way, you need to have access to both income statements and cash flow statements.

Now, let's calculate the dividend payout ratio by using the usual ratio.

If we compare the dividend ratio for both years, we would see that in 2016, the dividend payout is more than the previous year. Depending on where the company stands in the level of maturity as a business, we would interpret it. If ABC Company is beyond the initial stages of development, this is a healthy sign.

In the next example, we will see an extension of the previous example. But the computation method of the dividend payout ratio would be different.

Example # 2

Let’s look at the Income Statement and Balance Sheet of ABC Company for the year 2015 and 2016 –

Balance Sheet of ABC Company

Note: It is assumed that all the earnings (except the retained earnings) are paid out in the form of the dividend is both the years.

In this example, we need to calculate the dividend payout ratio where we don't know exactly how much dividend is given.

We will follow the alternative formula of ascertaining dividend payout ratio –

Dividend Payout Ratio Formula = 1 – (Retained Earnings / Net Income)

Or, Dividend Payout Ratio Formula = (Net Income – Retained Earnings)/Net Income

Example # 3

MNC Company has distributed a dividend of US $20 per share in the year 2016. The earning per share for MNC in the same year is US $250 per share. Calculate the Dividend Payout Ratio of MNC companies.

In this case, we would use this alternative formula –

Let's look at a practical example to understand the dividend ratio better –

source: ycharts

Till 2011, Apple didn't pay any dividends to its investors. Because they believed that if they reinvested the earnings, they would be able to generate better returns for the investors, which they eventually did.

Let us now perform a Dividend Ratio Analysis of Exxon. First, we note that Exxon's Dividend Payout ratio has been increasing since 2015. Why is that so? Is the company doing great and hence, increasing its Dividends disproportionately?

source: ycharts

There could be various reasons for the increase. 1) Increase in Dividends 2) Decrease in Net Income 3) Both 1 and 2

# 1 - Increase in Dividends

Below is the trend in Exxon's Dividends -

source: ycharts

We note from above that Exxon's dividend outflow has increased from $8.02 billion in 2010 to $12.45 billion in 2016.

# 2 - Decrease in Net Income

Let us now have a look at the trend in the Net Income of Exxon.

source: ycharts

We note that Exxon's Income decreased by 82.5%, from $44.88 billion in 2012 to $7.84 billion in 2016. This decrease is substantial and has led to the jump in Dividends Payout Ratio.

We can conclude that Exxon's Dividend Ratio increased due to both the Increase in Dividends Paid as well as the decrease in Net Income.

Global banks are large market capitalization banks that are mature and growing at a stable growth rate. In addition, we note that such banks have an optimal Dividend Ratio. Below is the list of Global Banks, along with their Market Capitalization and Payout Ratio.

• JPMorgan Chase, with Market Capitalization of $312 billion, has a payout ratio of 34.3%
• Citigroup has the lowest Payout Ratio at 15.3% in the above group
• HSBC Holding here is an outlier with a Dividends Payout Ratio of 369.4%

Most of the Tech Companies do not give any Dividends as they have greater reinvestment potential as compared to mature Global Banks. Below is the list of Top Internet-based companies along with their Market Capitalization and Payout Ratio.

Despite having a large market cap, Alphabet, Facebook and others do not intend to pay any dividends. Instead, they believe that they can reinvest profits and generate higher returns for the shareholders.

The negative dividends ratio happened when the company paid dividends even when the company made a loss. This is certainly not a healthy sign as the company will have to use the existing cash or raise further capital to pay dividends to the shareholders.

Below is the list of Oil & Gas Exploration & Production companies that are facing a similar situation.

The dividend ratio always doesn't clarify the investors about the company. There are a couple of things that can be called disadvantages. Let's have a look at them –

• First of all, dividend payments are not always similar every year. It depends on many highly volatile factors. And dividend payment also changes with the available investment opportunities.
• In the investment world, investors want quick fruits. Their desire for instant gratification results in a lower valuation of a company if the company is unable to pay dividends to its investors.

Both the terms help investors determine their earnings per share so that they know the final income they would generate from the investments they make. Both let investors assess how well a company stock is expected to perform. In short, the parameters let them evaluate their earning potential. However, these terms differ widely in many other aspects.

Let us look at the differences between the two:

This has been a guide to what is Dividend Payout Ratio. Here, we explain it with formula, its interpretation, examples, vs dividend yield, and determinants. You may learn more about financing from the following articles –

• Dividends in Arrears Definition
• Calculate Win/Loss Ratio
• Formula for Dividend Growth
• Compare - Dividends Ex-Date vs. Record Date