What Does a Payout Ratio Tell?

by Tom Streissguth

    When researching a potential investment, dividend payout ratio is a good statistic to know. This number reveals how much of its earnings a company is returning directly to shareholders. At the discretion of company management, dividend payout is a good clue to how a company chooses to deploy its money and how it approaches investor relations.

    A dividend is a regular payment to shareholders taken out of a company's net income. Not all publicly-traded companies offer dividends; start-ups and smaller companies usually retain earnings to invest for future growth. Larger companies, and those with a steady stream of reliable income, pay dividends as a way of keeping shareholders loyal and of making their stock more attractive to new investors. Most companies that pay dividends make the payouts quarterly.

    The payout ratio is the percentage of net income paid to shareholders in the form of dividends. If a company earns $1 a share and pays a dividend of 10 cents, then the payout ratio is 10 percent -- .10 divided by 1 multiplied by 100. There are no requirements to maintain a certain payout level, although many companies strive to protect their dividends and, if possible, continually increase them as their net earnings rise.

    A payout ratio reveals quite a bit about a company's financial strategy. A low ratio means relatively little income is paid out to shareholders, and instead the company is choosing to retain its earnings and reinvest in new plant, equipment, markets and research. Higher ratios mean further expansion is not a high priority; the company feels its business and earnings are relatively stable and shareholder dividends are the best way to support the stock price. Very high ratios, however, mean that the company is risking a future dividend cut, which will in most cases bring down the stock price.

    Some industries, such as banks, insurance companies and utilities, traditionally have relatively high payout ratios. Others, such as high-tech firms, generally deploy their earnings toward new investment. Occasionally, a company will use earnings to buy back shares, reducing the number of shares on the market and thus boosting the earnings-per-share number. Some investment vehicles are required to pay out a minimum percentage of their income. For real estate investment trusts, or REITs, this figure was 90 percent in 2012.

    About the Author

    Tom Streissguth has worked for over 15 years in the legal field as a writer and legal assistant, and has authored numerous articles on Social Security disability law. He has many nonfiction and reference titles in print, including works for The Gale Group and Lerner. He holds a Bachelor of Arts from Yale University.

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