If you interested in investing in dividend paying stocks, then you must understand the dividend payout ratio. The dividend payout ratio is simply the amount of dividends paid divided by the total net income of a company. Many dividend stock investors use this all-important ratio to determine the dividend’s long-term sustainability.
How to Calculate the Dividend Payout Ratio
In order to calculate the dividend payout ratio, you will need to know the amount of yearly dividends paid out to the shareholders also known simply as dividends and the total yearly net income of the company also known as net income or earnings per share. You want to divide the dividends by the earnings per share to get the ratio.
For example, let’s pretend stock “A” pays out a dividend of $4 per share per year and the company has yearly net earnings of $12 per share. You would then divide the dividend ($4) by the net earnings ($12) to get a dividend payout ratio of 33.33%. That means that a third of the money the company earns, as net income, is paid back to the shareholders.
Why is this Ratio so Important?
A dividend payout ratio is important because it shows how much money companies pay back to their shareholders. A dividend investor wants to buy a stock that will pay a reliable dividend over a long period of time. Therefore, the first piece of data the dividend investor will look at is the payout ratio.
Investors tend to look at a payout ratio over the long-term. For instance, if a stock has a rising payout ratio over the last ten years, that indicates that the company will most likely continue to pay a rising dividend for the next several years… or income is dropping. In fact, a select group of dividend paying stocks known as the “Dividend Aristocrats” distinguish themselves for paying rising dividends for at least a quarter century.
What is the ideal payout ratio for a dividend stock?
Dividend investors seek to find a “sweet spot” when it comes to a payout ratio. If the payout ratio is too low, that indicates the company may have room to raise its dividend. It’s even possible for a dividend to have a payout ratio of 0%. That means the company isn’t paying a dividend or it has negative earnings. They might be paying dividends from their bottom line. Many dividend investors see this type of dividend payment structure as unsustainable.
Conversely, a high dividend ratio indicates that the company is paying out more than 75% of their net income as dividends. Many investors see this as dividend payout structure as unsustainable and at risk for being cut in the future. The ideal dividend payout ratio lies between 35% to 55%. That means about a third to a little over a half of a company’s annual net earnings are paid out to shareholders.
If you’re interested in learning more about dividend investing, check out our unique dividend investing articles.