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Payout ratios: meaning and significance

Updated on April 20, 2013
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Payout ratios: meaning and significance

Payout ratios or Dividend Payout ratios is a financial percentage to quantify the amount of net earnings paid in form of dividends to shareholders. The mathematical formula is (Annual Dividend per Share/ Earnings per Share)*100. For instance, if AGNC, well-known dividend paying REITs, pays an annual dividend of $5 per share, Earnings per share is $6.40. Then, the current dividend payout ratio of AGNC is (5/6.40)*100 = 78.12%

Payout ratios, plays an important role to understand the financial health and maturity of the company. New or fast growing companies, that require lot of capital for growth, infrastructure, tend to reinvest their earnings back in the company growth, thus leading to low or zero dividend payout ratios. However, as companies mature and need less money for growth and infrastructure, they tend to attract investors by giving dividends and hence, payout ratio increases.

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Significance of Payout ratios: Payout ratio depends on the industry and work nature of the company. Certain industries like mortgage REITs tends to have high payout ratios. A balanced payout ratio is somewhere between 30-70%.

Too high payout ratio like above 80-90% is not considered healthy as it implies that the company might be just trying to attract investors and it might not be able to sustain or grow the dividend amount in coming years. Too low payout ratios like 10% is also not healthy as it means that the company is not sharing income with its shareholders.

Some investors who are looking for consistent monthly income tend to go for high quality stocks with good dividend payout ratios. Such companies, with high payout ratios, tend to have less likelihood to gain in stock value as most of the money is paid in dividends. Hence, when monthly cash flow is more critical than capital gain, investors go for companies with high payout ratios. The investors in this group tend to be retirees, low risk investors and people who have gained enough wealth, that monthly income from dividends is significant.

However, few investors whose main focus is capital gain and not dividends, might go for companies with good growth and low payout ratios. As all or most of the earnings is reinvested in the company itself, such companies tend to have high growth rate. Young investors, with less capital tend to look for growth companies and thus, tend to go for companies with low dividend payout ratios.

Hence, it is good for each investor to understand the type of returns they are interested, capital gain or cash flow. Based upon the choice of returns, they can look for payout ratios that suit them best. Investment education and guidance is recommended. Investments involve risk and understanding all risks, before embarking in the financial world is very important..

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    • rahul0324 profile image

      Jessee R 5 years ago from Gurgaon, India

      Useful....

    • Ruchi Urvashi profile image
      Author

      Ruchi Urvashi 5 years ago from Singapore

      Rahul, thanks.

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