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How to Calculate the Dividend Payout Ratio

Over the past few years, dividend growth investing has become one of my favorite investing strategies which is evident in the number of times I’ve written about the topic.  I follow the dividend growth investing strategy as it can generate a growing tax efficient income stream over time as well as the comfort of receiving a portion of the companies profits on a quarterly basis.

In most of  my previous articles about dividend investing, I mention the importance of giving attention to the dividend payout ratio.  As I’ve received this question from a reader, here are more details about what payout ratios are, why they are important and how to go about finding or calculating it.

What is the Payout Ratio?

Lets start off by explaining that the dividend payout ratio is the amount of dividends that a corporation pays out to shareholders relative to their net income (income after expenses) or earnings.  In the most basic form:

Payout Ratio = Dividends Paid/Earnings

or

Payout Ratio = Dividends per Share/Earnings per Share

Why the Payout Ratio is Important

The dividend payout ratio will tell you how much of net income that dividends are chewing up which is relevant in evaluating the sustainability of the dividend.  Generally speaking, payout ratios will vary by industry.  Utilities with very steady and predictable cash flow may have a relatively high payout ratio, while bank and financial companies will be in another range.  If earnings are poor, thus a higher payout ratio,  there is a probability of the dividend being reduced or eliminated as the management has that option to conserve cash.

How do you Find or Calculate Payout Ratios

The easiest way is to visit a website that does the calculations for you – like stockhouse.ca.  However, with this strategy, there are times when the ratios are not updated with the most recent earnings.  If you want to manually calculate payout ratio, you’ll need to pull the earnings and dividends data  from company financial statements.

For example, if I take a look at TD, a popular Canadian bank,  Google Finance tells me that in the most recent quarter, TD had a net income of  $1.30 per share (EPS) and dividends of $0.61 per share.  In this case, the payout ratio for the quarter was 47% which is fairly low for a bank.  In addition to looking at the quarterly numbers, I like to review annual reports in case the quarter was an anomaly.  In this case, for the trailing 4 quarters, TD has a payout ratio of approximately 50%.  As mentioned, I like to compare payout ratios by industry, so it would be good practice to compare the payout ratios of the big 5 banks.

For those of you who are really savvy, instead of calculating dividends as a percentage of earnings, you can calculate them as a percentage of free cash flow.

What is an Acceptable Ratio?

As I mentioned earlier, it’s difficult to say what payout ratios are acceptable as every industry has their own range.  However, if a company reports consecutive quarterly losses without a good strategy to get back to profit, then it’s a red flag that there could possibly be a dividend cut.  Remember, it’s up to the management as to how much the dividend is reduced or cut altogether.

For you dividend investors out there, how do you use payout ratios when determining valuation?







10 Comments, Comment or Ping

  1. One thing to perhaps keep in mind is that there are several ways to calculate the payout ratio. For example:
    - a period other than the current quarter may be used for earnings
    - different definitions of earnings– e.g. excluding/including special provisions
    - different kinds of dividends (e.g. special, stock vs. cash)

  2. 2. talcumboy

    Stock buybacks are another way that a company can increase the value of ones shares. I’ve read its valuable to calculate the payout ratio including dividends, stock buybacks and debt paydown.

  3. Thanks for clearing that up Larry.

  4. 4. Robert

    It is usually the board of directors that sets the dividend policy. They should be independent of management (ie. CEO, CFO, etc.).

  5. Just remember that dividend payout ratio calculations may be misleading for certain types of income trusts.

    The ratio, in and of itself, has no meaning. You have to look at the ratio based on the type of business and industry. If it is a growing business, a high ratio sets off alarm bells since they could be paying too much money to the shareholder and not reinvesting enough of it and valuations set accordingly. In a mature business, too low a ratio may mean the directors are hoarding money and not returning to shareholders. What is low or high requires comparison between industry peers.

  6. 6. Andrew F

    One might also want to consider cash returned to shareholders via share repurchases. Since this is often more advantageous for shareholders tax-wise (esp. in the US), more and more corporations are employing this strategy.

  7. 7. Jungle

    Also, look if the company is paying out interest from bonds. You should also consider that when judging the companies ability to pay out income..

  8. 8. Jungle

    Sorry let me write that again:

    If the company has coperate bonds then they are paying out interest. This should be factored in the income payout.

  9. 9. Echo

    I agree that certain industries have different levels of acceptable payout ratios. If I were to choose between two companies in the same industry, and all other things being relatively equal (dividend yield, consecutive years of dividend increases, dividend growth rate), I would definitely pick the company with the lower payout ratio. Less risk, and more likely to increase their dividend ahead of their competition.

    Ex. EMA vs. TA, or T vs. BCE

    I wonder which of the banks will be the first to raise their dividend? My guess would be NA, RY, and then TD.

  10. 10. Million dollar man

    Within the same industry, I would pick the stock with the high dividend yield and the lowest payout ratio. Does that make sense to everyone?

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