What is the dividend payout ratio?
The dividend payout ratio is a financial metric that companies use. It shows how much of a company’s earnings are paid out as dividends to shareholders. You calculate it by taking the total dividends paid and dividing by the company’s net income. Net income means the profit the company made.
The formula looks like this: Dividend Payout Ratio = Total Dividends Paid / Net Income
An example of calculating dividend payout ratio
Let’s say Acme Corporation made $10 million in net income last year. Out of that profit, they paid $2 million in dividends to shareholders who own Acme stock. To calculate Acme’s dividend payout ratio, you divide the $2 million in dividends by the $10 million in net income.
$2,000,000 / $10,000,000 = 0.20 or 20%
This 20% dividend payout ratio means Acme paid out 20% of its profits as dividends. The other 80% it kept to reinvest in growing the business.
What the dividend payout ratio tells you
The dividend payout ratio gives you a sense of how much of its profits a company is giving back to shareholders versus keeping to fund operations and growth. A higher ratio means the company is paying out more of its income to shareholders. A lower ratio means it’s reinvesting more profit back into the business.
Mature, established companies tend to have higher payout ratios. They don’t need to reinvest as much to keep growing. Younger, rapidly expanding companies usually have lower ratios. They need that cash to fund their growth.
Does dividend payout ratio equal dividends divided by sales?
Now that you understand what the dividend payout ratio is, let’s look at the main question. Is it true or false that the dividend payout ratio equals cash dividends divided by sales?
The answer is false. The dividend payout ratio does not equal cash dividends divided by sales. This is a common misconception. But sales and net income are two very different things.
Why dividends divided by sales is wrong
Remember, the actual formula for dividend payout ratio is:
Dividend Payout Ratio = Total Dividends Paid / Net Income
Sales, also called revenue, is the total amount of money a company collected from selling its products or services. Net income is the profit left over after subtracting all the costs and expenses of running the business from the sales.
Profit is what’s left over from sales after paying for things like salaries, rent, supplies, taxes and more. Sales are what’s collected from customers before accounting for all those costs. They are not the same thing at all.
An example showing the difference
Imagine a lemonade stand. They sell $100 worth of lemonade one day. That $100 is their sales or revenue.
However, to make that $100, they had to spend money first:
- $20 on lemons
- $10 on sugar
- $30 for the kid’s time spent selling
- $5 on cups
- $5 for their lemonade stand permit
That’s $70 in total costs. If you subtract the $70 in costs from the $100 in sales, you get $30. That $30 is the lemonade stand’s profit or net income.
If the lemonade stand wanted to pay half its profit as a “dividend” to the kid who ran it, it would pay them $15. That’s 50% of the $30 profit.
In this case, the dividend payout ratio is: $15 dividend / $30 profit = 50% payout ratio
But if you did it wrong and used sales instead of profit, you would get: $15 dividend / $100 sales = 15% payout ratio
That 15% figure is very wrong. Using sales instead of profit dramatically understates the true ratio. The real amount of profit they paid out is 50%, not 15%.
Why the dividend payout ratio matters
Importance for investors
The dividend payout ratio is important for investors, especially those focused on income. Investors like to see steady, predictable dividends.
The payout ratio helps predict the sustainability of those dividends. If a company consistently pays out more in dividends than it earns in profit, that’s a red flag. It may be borrowing money to fund those dividends. That’s not sustainable over the long run.
A payout ratio over 100% means a company paid more in dividends than it made in net income. That’s worrying. But the ratio needs to be looked at over multiple years to get the full picture.
One year of profit decline leading to a high payout ratio may not be concerning if the company has a good track record. But multiple years of that pattern could spell trouble. The company may have to cut its dividend.
Insight into capital allocation
The dividend payout ratio also gives insight into how a company chooses to allocate its money. This is called capital allocation.
Does it give a bigger portion of profits back to shareholders? Or does it keep more to reinvest in growing the business? There’s no universally right or wrong answer. It depends on the company’s maturity and growth prospects.
Rapidly growing startups often pay no dividend at all. They need every dollar of profit to fund expansion. More mature companies that still have some growth left might pay a modest dividend. They split their profits between shareholders and reinvestment.
Then you have very established, slow-growth companies. Utilities and telecoms are classic examples. They often pay out the majority of their profits as dividends. They return that cash to shareholders since they don’t have many profitable growth opportunities left to fund.
Comparing payout ratios
You can’t necessarily compare dividend payout ratios across very different kinds of companies. What counts as a high or low ratio varies by industry.
For example, real estate investment trusts (REITs) are required by law to pay out at least 90% of their income as dividends. So nearly all REITs will have high payout ratios. That’s normal and expected for them.
In contrast, technology companies often have very low or nonexistent ratios. Even mature tech giants like Google still have lots of growth potential. They reinvest nearly all of their profits rather than pay dividends.
So you have to compare payout ratios between similar companies. Look at the ratios of a company’s close competitors, not the market as a whole. Even then, having a higher or lower ratio than competitors isn’t automatically good or bad. You have to understand the reasons behind it.
Key takeaways
Let’s review the key points about whether dividend payout ratio equals dividends divided by sales:
- This is false – dividend payout ratio does not equal dividends divided by sales
- The actual ratio is dividends divided by net income (profit)
- Sales and profit are not the same thing at all
- Using sales instead of profit dramatically understates the ratio
- The dividend payout ratio shows the sustainability of dividends
- It also gives insight into how a company allocates capital
- You have to compare ratios between similar companies, not the market as a whole
- A higher or lower ratio isn’t automatically good or bad without context
