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Dividend Payout Ratio: Meaning, formula, and calculation

4 Mins 29 May 2023 0 COMMENT

Any profit-making company has two choices – it can either retain its profits and use them to pay off its financial obligations and reinvest or it can distribute them among its shareholders. Dividend is the share of the company’s profit it distributes among its shareholders.

Note, that dividend offering is only possible if the company is profitable. Furthermore, the offering is based on several factors like the profits generated, potential investment opportunities, industry trends, and the company’s dividend payment history.

Every company formulates a dividend payment policy. As the name suggests, the policy provides all details about the company’s dividend distribution. Dividend payout ratio and frequency of dividends are two key pointers to check out in the policy. The article explains the concept of dividend payout ratio in detail. Read on. 

What is dividend payout ratio?

Dividend payout ratio is a financial ratio that defines the relationship between the company’s dividend payments and net income for a specific time frame. In simple terms, the ratio is the percentage of the company’s net income distributed among shareholders as dividends. It is expressed as a percentage.

A company may decide to share 100% or a decent portion of its net income as dividends. The amount of profits retained is used by the company to clear its debts and other financial obligations. The amount can also be reinvested to boost the company’s growth. This is solely the company’s decision.

Dividend payout ratio is an important financial indicator to refer to. It gives you a fair idea of the dividend you can earn by investing in a company’s stocks. It also helps you gauge the company’s sustainability. If the company has a higher dividend payout ratio than it can afford, it can face severe financial crunches down the line. Knowing such details about a company comes in handy in making informed investment decisions.

How is dividend payout ratio calculated?

Calculating the dividend payout ratio is very simple. You need to divide the company’s total dividend by its net income. The dividend payout ratio formula can be expressed as follows:

Dividend payout ratio = Total dividend / Net income

Let’s consider an example to better understand the calculation of dividend payout ratio: ‘Company A’ is an emerging company that makes a net income worth Rs 10 lakh in a financial year. It plans to extend dividend payments of Rs 20,000 every quarter. This adds to dividend income worth Rs 1,00,000 in a financial year. Using the dividend payout ratio formula you derive the following equation:

Dividend payout ratio = (1,00,000/10,00,000) x 100 = 10%

The calculation indicates that Company A distributes 10% of its net income as dividends to its shareholders. It retains 90% of the net income to clear its debts, and other financial obligations, and reinvest in the company’s growth.

How to interpret the dividend payout ratio?

Here’s how you can interpret the obtained dividend payout ratio:

  • Higher dividend payout ratio – The ratio indicates the company is distributing a huge chunk of its net income as dividends to its shareholders. It retains a small or no portion of the net income for reinvestment or debt clearing.
  • Lower dividend payout ratio – The ratio indicates the company distribute a small portion of its net income as dividends. It retains the maximum of its net income to reinvest and boost the company’s growth and development and settle its ongoing debts.

Note, that you must not merely base your investment decisions on the dividend payout ratio. Along with the ratio consider the following two pointers to make informed and profitable investment decisions:

  • Company’s maturity level

Any company’s dividend payout ratio is largely influenced by its maturity level. Generally, most small, growing companies have a low dividend payout ratio. This is because they mainly choose to retain the maximum portion of their net income and reinvest it in the company to grow.

Any small, growing company having a high dividend payout ratio may not be a strong case before an investor. In such a case, the higher ratio indicates the company isn’t prioritising its growth. Such a company may struggle to sustain itself and may not have the necessary financial resources to scale up in the future.

Contrastingly, large, well-established companies typically have a higher dividend payout ratio. Since the company is already well-established it may not require a significant amount of reinvesting to grow. Given this, the company can share the maximum of its net profits as dividends with its shareholders. In fact, many investors consider companies offering a high dividend payout an attractive investment opportunity.

  • Industry

The industry the company is operating in makes a significant difference in its profit generation and subsequently its dividend payout ratio. For instance, companies in the industry that require heavy reinvestment from time to time for research and development will have a lower dividend payout ratio.

On the other hand, companies in the industry that do not require significant reinvestment from time to time can offer higher dividends to shareholders. Conduct an extensive industry analysis before investing. It will help you gauge the capital gains and dividend earnings you can make.

What is dividend yield?

The dividend yield is a financial ratio that indicates the company’s dividend payout, relative to its stock price. It is calculated by considering the aggregate of the dividend payments made in a financial year.

A maximum number of people find themselves confused between the dividend payment ratio and dividend yield. Note, the dividend payment ratio expresses the percentage of net income that’s offered as a dividend payment. While dividend yield expresses the return rate at which dividend payments are extended. The two financial ratios are not the same but closely interconnected.

Bottom line

Dividend payment ratio is the percentage of the company’s net income distributed as dividends. It can be calculated by dividing the total dividend by net income. Referring to the ratio gives a fair idea of the dividend income you may earn on investing in a stock. Investors should consider all related factors before making investing decisions.

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