The dividend payout ratio (also known as payout ratio) measures that how much amount is being paid as the dividend to investors from yearly earnings of a company. The amount which is not paid as the dividend, held by the company for growth is called retained earnings.
Dividend Payout Ratio = Dividend / Net Income
= Dividend per Share / Earning per Share
A listed company X with 1 million shares issued in a market, is specialized in electric cables manufacturing, its recent year financial statements are abstracted as under:
Profit before tax = $600,000
Dividend paid per share = $0.10
Currently, government tax rate is 25% in the country where the company has its manufacturing unit.
Profit after tax = 600,000– (600,000*0.25) = 450,000
Net earnings per share = 450,000 / 1 million shares = 0.45
Dividend Payout Ratio =Dividend per Share / Earning per Share = 0.10 / 0.45 = 0.2222 * 100 = 22.22%
This means that 22.22% of total earnings were paid as dividend last year and remaining 77.77% were retained for growth which is called retained earnings. Normally, a fast growing company often pays less dividend (have less payout ratio) whereas a mature company pays more dividend.
The ratio is important to measure the sustainability of the dividend. A high payout ratio means that the company is plowing back the small portion of its income for growth, which might be not a safe and alarming situation for investors, leaves the company susceptible to a decline in future dividend payments.
If the ratio is decreasing continuously, this means that the company will no longer able to pay the high dividend in future due to difficulties in operating performance.
It will be difficult to measure the ratio of two different industrial companies like banks pay more dividend than technology companies. So it depends on investor’s choice that whether they prefer long term investment and invest in growing companies with less payout ratio or choose short term gain by investing in mature companies which pay more dividend.