- Personal Finance»
- Understanding Finance
Dividend Payout Ratio
The Dividend Payout Ratio measures how much of the profit (in finance terminology: earnings) is paid out to shareholders. The result of the formula is a fraction rather than an absolute number. The Dividend Payout ratio is very similar to the payout ratio; in fact they are almost identical. As a result the Dividend Payout Ratio is also and inverse of the plowback ratio.
There are three ways in which the Dividend Payout Ratio can be calculated.
Dividend Payout ratio = Total Earnings – Plowed Back Earnings
Dividend per Share / Earnings per Share
Dividends / Net Income
The Dividend Payout Ratio is very easy to understand.
It gives a clear clue as to whether the management is planning large investments or not. Obviously when they plan investments, payouts decrease. The ratio is a clear indicator whether the managers of the company are optimistic, or pessimistic about the near future of the company.
A disadvantage of the ratio is that there is no standard across industries. In high growth and in low profitability ratio sectors generally the payout ratio is very low. In case of companies with high growth the profits are plowed back into the company to fund the growth. In low profitability sectors, such as for example the airline industry, profits are added to the financial reserves of the company, or to finance the future renovation/replacement of their production facilities.
The dividend payout ratio is does not describe the financial status of the company and the performance of the company. It also doesn’t tell whether the company is under-, or overvalued. For such reasons the only use of the ratio is to determine the exit date, no purchase of the stock should be based on this ratio.
The fact that there are a number of ways to calculate the payout ratio, it gives a degree of flexibility to the calculation, based on the sets of data available.