What Does a Payout Ratio Tell?

by Will Gish

One of the many things to pay attention to when investing in stock is whether a company pays dividends to its shareholders. For those stocks paying dividends, the payout ratio constitutes an important aspect of that stock's return value. Investors use this ratio to determine information about dividend payments and the relationships between the investor, the company issuing the shares and the amount of capital paid in dividends each year.

Payout Ratio

The payout ratio of a stock tells how much money a company pays out each year in dividends. Dividends constitute a portion of a company's profit shared among all owners of the business, including its shareholders. Companies usually pay dividends on an annual basis, though some may do so quarterly, or every three months. Investors use the payout ratio to determine not only dividend payments, but also whether a company can sustain its level of dividend payouts without facing financial difficulties in the future.

What It Indicates

The level of a payout ratio indicates how much annual profit a company reinvests in itself and how much it shares with its owners. A company with a high payout ratio pays a large portion of its profit to shareholders, while a company with a low payout ratio pays a small portion of its profits to shareholders and invests the rest in the business itself. According to the book "Reading Financial Reports for Dummies," young companies generally maintain low payout ratios as a means of growing the business through substantial reinvestment, while mature, established companies maintain the highest payout ratios.

Reading the Numbers

Payout ratios appear on paper as either decimals or percentages. For instance, a payout ratio may read "30 percent" or "0.30." Accountants calculate payout ratio in a handful of ways, the simplest of which entails dividing a company's annual dividend-per-share payout by its earnings per share (EPS). For instance, assume a company paid out 50 cents per share while posting an EPS of $1.50. This company maintains a payout ration of 50/150, or 30 percent (0.30). You can calculate your own payout ratio easily using this formula.

Desirable Ratios

Common investing wisdom holds that lower payout ratios prove more sustainable, and therefore ultimately more profitable, in the long term. For instance, a payout ratio of 30 percent means that a company pays 30 percent of its profits to shareholders while reinvesting 70 percent in the business, thus maintaining a healthy balance between dividends and reinvestment. A company with a dividend payout ratio of 60 percent may earn you more capital over the course of a few years, but a company only reinvesting 40 percent of its profits may experience difficultly growing or even stabilizing.

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