What is a Dividend Payout Ratio?

Dividend payout ratio is very important when you look at any dividend stocks. In fact, this is part of the 5 most important dividend ratios should you look at. This article will explain you what is a dividend payout ratio, how to calculate it and why it is so important.

What is a Dividend Payout Ratio?

Dividend payout ratio is the proportion between dividends per share and earnings per share that a company pays to the shareholders. This percent tells you the amount of cash that a company pays in dividends, to shareholders, from the total earnings. Here’s the Dividend Payout Ratio Formula:

Dividend Payout Ratio = Dividends per Share / Earnings per Share

A short example will help you understand this notion better. If a company that has total earnings of $4 per share, but decides to keep $3 for investments and future growths and to pay dividends of only $1 per share, to the shareholders, you can calculate the dividend payout ratio yourself: 1$/4$=0,25 – that’s a 25% payout ratio.

Different Company Stage – Different Dividend Payout Ratio

Most companies retain, each year, a part of their earnings for investments, and distribute to the shareholders the rest of the money. Small, emergent companies tend to keep a big part of their earnings for growing, and will pay small, or no dividends at all. Such companies will have small dividend payout ratios. Big, well-established companies, on the other hand, pay a bigger part of their earnings to the shareholders, thus they have high dividend payout ratios. The question is: should you invest in companies with high or low payout ratios?Well, the answer is not as simple as you might think and there are a lot of factors you need to consider.

High payout ratios – things you need to know

If you want to invest you money in dividend paying companies, there is one important question: should you place your money in companies that offer high payout ratios or, on the contrary, in companies that limit the amount of dividends they pay to the shareholders?

Well, your first instinct would be to pick the companies that offer you high dividend payment ratios thinking company are sharing most of their profit with the shareholders (read YOU!).

However, that’s not always or not necessarily the best choice. When it comes to investing money, there are a lot of factors you need to take into account. If you invest in a company that usually pays dividends at high payout ratios, you need to wander for how long that company will be able to continue the payments?

A company that has a 100% payout ratio probably won’t succeed to remain competitive. Distributing all the money to the shareholders, as dividends, means that there is no money left for investments, for development, for bringing in new technologies and for keeping the business competitive. So, a very high dividends payout ratio is virtually impossible to be maintained on the long-term. Sooner of later, that company will either go out of business or will have to stop paying dividends all together for a while.

What is the Perfect Dividend Payout Ratio?

The best strategy to invest your money is to select companies that offer you a decent dividend payout ratio, but still keep a part of the money for future growth. Dividend payout ratios between 30 % and 60 % tell you that you are dealing with responsible companies, which are interested in providing good, stable returns to the shareholders and in the same time to maintain a healthy, solid business running. When you look at the best dividend stocks, most companies able to maintain a solid dividend payout throughout several years will rarely exceed 60% in term of dividend payout ratio.

What low payout ratios mean and when to invest in such companies

When a company decides to pay only a small fraction of the earnings to the shareholders, as dividends, it means that the company concentrates on growing. Generally, that’s the case of smaller companies. Buying shares to such companies might be a good idea.

Even if you don’t make cash on the short term, there are great perspectives for the future. There is a direct connection between the dividend payout ratio or a company and the price of the shares. Companies with low dividend payout ratio tend to have cheaper shares, while companies with high dividend payout ratio also have pretty expensive shares.

If you buy cheap shares to a growing company, which doesn’t pay high dividends yet, over time you will enjoy great returns. So, if you are interested in capital gain and long-term investments, don’t ignore dynamic companies, only because they offer you low dividend payout ratios. The best way to build a solid, profitable investments portfolio is to place your money both in well-established, big companies and in small, emergent ones. This way, you’ll enjoy nice dividends from companies with high payout ratios and, in the same time, you have the opportunity of high returns on the long run, with emergent companies.

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