How to Calculate and Use Dividend Payout Ratio?

How to Calculate and Use Dividend Payout Ratio?

What is a Dividend?

Dividends are usually cash payments to shareholders from a company’s profits. Companies pay dividends from their profits as a return to shareholders. However, companies do not pay all their earnings per share as a dividend. Therefore, a measure of dividend safety is the dividend payout ratio and an investors should understand how to calculate it.

Dividends are usually paid quarterly in the United States. However, some net lease REITs pay monthly dividends, and a few companies pay bi-annual or annual dividends. Bi-annual or yearly dividends are more prevalent in countries other than the United States. Some companies will also pay special or one-time dividends from excess cash on the balance sheet. Yet, other companies will be a periodic stock dividend. Companies that raise their dividend yearly are referred to as dividend growth stocks.

Companies may cut dividends, and some may suspend them during recessions or due to a decline in earnings.

What is the Dividend Payout Ratio?

The dividend payout ratio is the annual dividend per share relative to the earnings per share. It is commonly expressed as a percentage. Hence, the payout ratio is the fraction of net income or profits paid as dividends to shareholders. The profits not used to pay dividends are reinvested in the company, used for mergers and acquisitions, paying down debt, or conducting share buybacks.

The dividend payout ratio varies depending on the sector and industry. Companies in a mature industry with stable earnings tend to pay more of their net income as dividends and thus have high payout ratios. For example, Utilities may have a payout ratio between 60% and 85%. On the other hand, companies in cyclical industries usually have lower payout ratios. For instance, Consumer Discretionary or Technology companies may pay only 20% to 30% of their earnings as dividends.

The dividend payout ratio is not the same as the dividend yield. The dividend yield is calculated as the dividend rate divided by the stock price. It is a measure of return to an investor.

How to Calculate Dividend Payout Ratio?

To calculate the dividend payout ratio, you need to dividend the total dividend paid by the net income. Another way to perform the calculation is to divide the annual dividends per share by the earnings per share. The payout ratio formula is as follows,

Dividend Payout Ratio = Annual Dividend Per Share / Earnings Per Share x 100%

For example, if a stock pays $1.00 per share in dividends and earns $2.00 per share, the payout ratio formula is written as,

Dividend Payout Ratio = $1.00 / $2.00 x 100%

The payout ratio in this example is 50%.

The annual dividend payment can be found on many financial and company websites. It is four times the quarterly dividend rate.

How to Calculate Forward Payout Ratio?

Two versions of the payout ratio exist. The forward dividend payout ratio is the current dividend rate multiplied by four for the next four quarters. This percentage helps know if the dividend is covered by earnings in the future. The trailing twelve months (TTM) payout ratio is based on the actual payments in the past four quarters.

For example, the table below shows the date and quarterly dividend payments for Johnson & Johnson (JNJ). The firm is a well-known Dividend King and Dividend Aristocrat. Johnson & Johnson increased the dividend on April 19, 2022, to $1.13 from $1.06 per share.

Hence, the TTM annual dividend is $4.38 per share, and the forward annual dividend rate is $4.52 per share. The consensus earnings are $10.04, giving a payout ratio (FWD) of ~45%.

Investors can also compare the adjusted and Generally Accepted Accounting Principles (GAAP) payout ratios based on adjusted and GAAP earnings. Non-GAAP results are adjusted for one-time events, like restructuring charges, impairment charges, pension payments, etc. Consequently, the adjusted payout ratio is usually greater than the GAAP payout ratio.

Other Versions of Payout Ratio

Sometimes, investors prefer to determine the dividend-to-free cash flow ratio. Free cash flow (FCF) measures the actual cash generated by a business after capital expenditures. It is also a measure of dividend safety. Earnings can be impacted by non-cash charges, making it an imperfect input for the payout ratio. However, dividend-to-FCF is not limited by that issue.

Consequently, if earnings cover the dividend but not FCF, it may not be safe.

Uses

The payout ratio is helpful in evaluating dividend safety. The metrics tell investors the degree of sustainability for the dividend. A firm with a low payout ratio will probably not cut or omit the dividend. Furthermore, they will likely keep increasing the dividend. This point is vital for investors following a dividend growth strategy. Companies with high payout ratios usually have low dividend growth rates and vice versa. On the other hand, companies with too high a percentage may not increase the dividend, or even worse, they may cut it. 

Generally, a payout ratio of approximately 65% or below is considered good for dividend safety. At higher percentages, the risk to the dividend is greater. Exceptions are Utilities and Consumer Defensive stocks that sometimes have higher payout ratios because of relatively stable earnings and cash flows. 

Real estate investment trusts (REITs) and master limited partnerships (MLPs) tend to have a payout ratio of up to 100% and sometimes higher. For example, net lease REITs often pay more than 100% of their earnings as dividends. However, utilizing adjusted funds from operations (AFFO) for REITs and distributable cash flow (DCF) are more valuable metrics to calculate dividend coverage for REITs and MLPs, respectively.

The payout ratio is also a measure of company maturity. Younger, rapidly growing companies typically do not pay dividends. Even large companies with better reinvestment opportunities do not pay dividends. In both cases, the payout ratio is zero. For instance, Google, Amazon, and Tesla do not pay dividends, and their payout ratios are zero.

Final Thoughts

Calculating the dividend payout ratio is necessary to evaluate dividend safety and potential growth rates. The formula is simple to comprehend, and the calculation is easy, allowing investors to determine the payout ratio quickly. Besides the ratio, investors should evaluate credit rating, net debt, leverage ratio, interest coverage, and earnings growth for dividend safety. Economic and business conditions can rapidly change, making relying only on the payout ratio circumspect.

Thanks for reading How to Calculate and Use Dividend Payout Ratio!

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Published at Wed, 19 Oct 2022 04:00:00 -0700