Dividend payout ratio – my three favourite words after, “Today is payday.”
So, you probably know by now that dividends are freaking awesome. After all, a company will pay you a slice of the profits for just owning their damn stock. A ‘thank you’ for trusting them with your hard-earned cash.
Of course, if they’re paying you a slice of the profits, then you know your money is being spent well. Instead of being splashed out on booze, whores and drugs for the executive board.
However, there’s also a much fancier way to see just how well your investment is being spent and it’s something called the dividend payout ratio. Before you think this will be as difficult as learning to speak Latin, fear not because we’ll break down what the dividend payout ratio is and how you can use it – even if you’re allergic to math.
Ready? Let’s do this…
What is the dividend payout ratio?
The dividend payout ratio tells us how much money a company is returning to its shareholders, in the form of dividends, compared to how much they earned that year.
Why would a company want to keep some of their profits and not share it all with us? Whilst they may be cheeky bastards, a company may keep some profits to reinvest for growth or to pay off debt.
OK, but is it a good thing or bad thing when a company decides to share all the profits with its shareholders? (It can happen!) And what if they decide to share none, keeping it all in the company instead? Before we can answer that question, we need to know how this damn thing is calculated. And most importantly, how the dividend payout ratio compares to the dividend yield – they sound the same but they’re not.
Dividend payout ratio vs dividend yield
If you’re mixing your dividend yield with your dividend payout ratios, that’s understandable.
Dividend yield is how much a company is paying out in dividends to its shareholders relative to the company’s share price. Effectively, it tells you how much cash you’re getting back for each dollar you invest.
Meanwhile, the dividend payout ratio tells us how much the company is paying out vs. how much they’re keeping to themselves.
Both are very powerful formulas that can supercharge your trading!
How do you calculate the dividend payout ratio?
It’s simple, Simon. In fact, as you’ll see below:
Dividend Payout Ratio = Total Dividends / Earnings Per Share
Let’s say, for example, Awesome Company reports earnings per share to the amount of $1.20, $1.10, $1.25 and $1.15 over the last four quarters. That would amount to a total yearly earnings of $4.70 per share. Now let’s say during that same year, Awesome Company paid out $3.10 in dividends per share to its shareholders.
If we divide the total dividend of $3.10 by the total earnings of $4.70, then we get a dividend payout ratio of roughly 65%. (Whip out your calculator for this.) Now that you’ve managed to punch in the right numbers on your calculator – you may ask, what the heck does the 65% mean?
It basically means that Awesome Company paid out 65% of its profits as dividends in that year. That also means it kept 35% of the profits for either a lavish holiday for its employees or, more likely, to pay off debt or to invest in new innovation and growth.
Now, you’re probably thinking…
How do you know if a dividend payout ratio is good or bad?
This is a good question and it really depends on whether the company is just starting out or if it’s a seasoned veteran like, say General Electric, which has been around since the dawn of man.
A new startup may have a low, or even zero, dividend payout ratio because it’s pumping all its profits back into developing new products, buying out other companies to help it grow, or a whole host of other reasons.
However, a more established company that’s been around the block for some time can’t get away without paying any profits to its shareholders. It will be expected to share the love, so it will probably offer a higher dividend ratio to keep its investors sweet.
But if the dividend payout ratio is greater than 100%, that could be a red flag…
If a company’s dividend payout ratio is over 100%, that means it’s returning more money to its shareholders than it is making. This is clearly not a good sign. It means that in time, the company could be forced to lower the dividend amount, or stop paying one altogether, until it gets profitable again.
This could spell trouble for the share price as investors take their money and run. Because they will likely prefer to park it into another company that is growing and more likely to increase its dividends over time. After all, it’s all about the money, baby!
How do I get me some of those dividends?
When you trade with BUX, you’re entitled to dividends when companies pay them. Find out how and when dividends are paid with BUX.