The Payout ratio is a reverse of the plowback ratio; it is simply the percentage of the company gross profits of the company (or which the recipients still needs to pay taxes).
The formula for the payout ratio is:
Payout Ratio = Total Dividends / Total Gross profit.
Another way to calculate the figure is as follows:
Payout Ratio = Dividends per Share / Earnings per Share
Still there is a third way to calculate it, however this one is not as often used:
Payout Ratio = (Total Gross Profit – Plowback Ratio) / Total Gross Profit
The 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.
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.
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 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.