Solutions to Paid Dividends Using Profitability Ratios

by Wilhelm Schnotz, studioD

Even the most novice investor understands that profits drive a company’s dividends. Although it’s obvious that a company that isn’t turning a profit isn’t going to have profits to share with investors through dividends, the link between profitability metrics and dividend declarations isn’t nearly as clear. In fact, investors shouldn’t look at a company’s profitability as a means to project its dividend payments, because dividend declarations are as much a matter of the company’s strategy as its performance.

Profitability Ratios

Accountants use different formulas to determine profitability ratios and apply each ratio as a measurement of a different type of performance. Gross profitability measures a company’s total margin, and it is determined by subtracting all costs from a year’s total revenue then dividing that figure by total sales. Operating profit margin helps determine a company’s overall profitability and is determined by dividing gross profits by total sales. Net profit margins paint a clearer picture, accounting for taxes and interest charges from a corporate structure, They are determined by subtracting taxes and finance charges from total profits and dividing that figure by total sales.

Dividend Basics

At the end of a reporting period, companies may use profits to declare a dividend. Before a dividend to common stockholders may be declared, however, the company must pay liabilities such as taxes, loans and bond debt. Any remaining funds are profits and are then paid to stockholders. Holders of preferred stock receive dividends first, based on a fixed per-share basis. If the company’s board chooses not to reinvest profits, it divides the total remaining profit by the number of outstanding shares. It returns this amount to shareholders on a per-share basis as a dividend. Profitability ratios don’t immediately impact these calculations.

Profit Ratios and Growth Strategies

Looking at any one of a company’s profitability ratios as a means to gauge its ability to provide dividends to stockholders may be misleading. Companies with an eye for rapid expansion may choose to forgo dividend payments and instead reinvest profits back into the company rather than taking on debt to finance that growth. Because of this, investors should consider a company’s growth strategy and profitability metrics -- as well as recent dividend history -- when attempting to predict dividend potential. Stock prices for companies with high profit ratios that don’t return dividends typically increase when profits are reinvested, and these stocks are known to investors as growth stocks.

Applying Profitability Ratios

Rather than attempting to use profitability ratios to provide solutions to a stock’s potential for dividends, investors should use them as one of many tools to gauge a company’s financial stability. While gross profit ratios provide a glimpse of the company’s overall ability to turn a profit, net profit ratios take into account taxes and financing, a tool that can indicate if a company’s corporate structure is wasteful or too burdened by debt to remain competitive.

About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.