For stocks that pay regular cash dividends, the earnings per share is the major factor concerning the amount and sustainability of the dividend payments. Investors looking for stock dividends use the relationship between dividends and EPS to differentiate between various dividend paying stocks.
Earnings Per Share
The earnings per share of a stock is the company's net profits divided by the number of shares outstanding for the company. U.S. companies report earnings results every quarter, and investors closely watch for the reported quarterly EPS. The total of the most recent four quarters of EPS is used to calculate a stock's price-to-earnings ratio. For most stocks, the EPS -- whether viewed quarterly or annually -- represent the profits available to pay cash dividends.
Dividing the dividends paid by the EPS produces what is called the dividend payout ratio. The ratio is typically calculated using the annual dividend amount and annual EPS. For example, IBM reports an EPS of $13.75 and pays a quarterly dividend of 85 cents. The $3.40 annual dividend divided into the EPS gives a payout ratio of 25 percent. The payout ratio indicates the amount of earnings available to cover the current dividend and the potential for future dividend increases.
Dividend Growth Factors
A company that increases its dividend payments over time must produce an increasing EPS to cover those dividends. For a period of time, a company can increase the dividend at the cost of an increasing payout ratio. However, investors looking for long-term dividend growth want to see the EPS growing as fast as, or faster than, the dividend growth rate. It is important for stocks with high payout ratios to be able to generate steady or growing earnings per share just to sustain the current dividend rate.
Dividend Payout Strategies
Each company sets its own dividend payout strategy, but those strategies can be divided into two broad camps. On strategy is to pay a steady dividend, with the amount of quarterly dividend increasing each year if the EPS justifies an increase. The other strategy is to base the dividend amount on the EPS, allowing the dividend to fluctuate up and down as earnings fluctuate. U.S. based companies typically follow the first pattern and many foreign companies with shares trading in the U.S. follow the second model.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.