What is the ‘Payout Ratio’
Payout ratio is the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage. The payout ratio can also be expressed as dividends paid out as a proportion of cash flow. The payout ratio is a key financial metric used to determine the sustainability of a company’s dividend payments. A lower payout ratio is generally preferable to a higher payout ratio, with a ratio greater than 100% indicating the company is paying out more in dividends than it makes in net income.
The Payout Ratio is calculated as follows:
Payout Ratio = Dividends per Share (DPS) / Earnings per Share (EPS)
Also known as dividend payout ratio.
BREAKING DOWN ‘Payout Ratio’
For example, Company X with earnings per share of $1 and dividends per share of $0.60 has a payout ratio of 60%. Company Y with earnings per share of $2 and dividends per share of $1.50 has a payout ratio of 75%. Which company has the more sustainable payout ratio?
It really depends, since there is no single number that defines an appropriate payout ratio. The adequacy of the payout ratio depends very much on the sector. Companies in defensive industries – such as utilities, pipelines, and telecommunications – have stable and predictable earnings and cash flows, and thus can support much higher payouts than cyclical companies. Companies in cyclical sectors like resources and energy typically have lower payouts since their earnings fluctuate considerably in line with the economic cycle.
In the previous example, if Company X is a commodity producer and Company Y is a regulated utility, Y’s dividend sustainability may be better than that of X, even though X has a lower absolute payout ratio than Y.
Many companies set a target range for their payout ratios, and define them as a percentage of sustainable earnings, or cash flow. The companies with the best long-term record of dividend payments have stable payout ratios over many years. While many blue-chip companies increase their dividends year after year, since they have steady earnings growth as well, their payout ratios remain remarkably stable over extended periods.