The payout ratio is the proportion of dividends that a company pays to its investors in relation to the total amount of its reported net income. Investors use it to assess the ability of a business to pay dividends. The ratio can be used to derive the following information:
- A high ratio indicates that the company's board of directors is essentially handing over all profits to investors, which indicates that there does not appear to be a better internal use for the funds.
- A low ratio indicates that the board is more concerned with the reinvestment of funds in the business, with the assumption being that investors will instead generate a return through the appreciation of their shares on the market.
- A downward trend in the ratio can indicate that the cash flows of the business are declining, so that less cash is available for dividends.
- An upward trend indicates that the cash flows of the business are increasing, which makes it easier for the company to support more payouts.
- A payout ratio of greater than 1:1 is not sustainable, and will eventually lead to a dangerous decline in the cash reserves of the business. The only exception is when non-cash expenses, such as depreciation and amortization, are driving down net income below the amount of cash flows that are actually being generated.
The calculation of the payout ratio is to divide the amount of dividends paid per share by the amount of net earnings per share, for which the formula is:
Dividend per share ÷ Earnings per share
The payout ratio can be misleading, because it compares a cash item (dividends paid) to an accrual-basis item (net income). It is entirely possible that a business may report a high net income figure without having sufficient cash flows to support large dividend distributions, so the relationship between the two figures can be murky.
From the perspective of an investor, the ratio should be either steady or upward-trending. Otherwise, those investors attracted to the stock because of its formerly reliable dividends will sell their shares, resulting in a reduction in the company's stock price.