When you invest in a stock, oftentimes you expect to earn income by receiving dividends. And knowing how much of a company’s earnings it pays out as dividends can tell you a lot about that firm. Enter: the dividend payout ratio.

After all, there are two basic ways you can earn profits from buying a stock. Those are:

1. Capital appreciation
2. Receiving dividends

Capital appreciation occurs when the price of the stock increases from the price you purchased it for. So if you buy the stock at \$60 and it increases to \$65, you’ve earned a \$5 profit (before taxes anyway).

Dividends are the other way that you can earn profits from buying a stock. Buying a stock is purchasing a percentage of ownership in a firm. And that ownership entitles you to a share of the company’s earnings. That’s what dividends are.

Firms don’t have to pay out all – or any – of their earnings as dividends when they are received. Companies have several options as to what to do with their earnings. These include:

1. Distributing them to shareholders as dividends
2. Investing them in new projects
3. Paying down debt
4. Retaining the earnings for later use (retained earnings).

But for a company that does distribute a dividend, a dividend payout ratio represents the total amount of dividends paid out to shareholders over a given period versus the earnings of the company during that same period.

In other words, the dividend payout ratio – sometimes just called the payout ratio – measures how much of the company’s earnings are distributed as dividends. It is a measure of how much money a company is giving back to its shareholders.

## Formula and Calculation

There are several different ways you can calculate the dividend payout ratio (DPR). The first one is to take the total amount of dividends paid over a period (e.g., one year) and divide it by the company’s earnings over that same period.

That formula would look like this:

Dividend Payout Ratio = Dividends Paid / Earnings

On the other hand, instead of looking at total dividends and earnings, you can look at them on a per-share basis. If you want to use this formula, you take the dividends distributed per share and divide it by earnings per share over the same period.

That formula would look like this:

Dividend Payout Ratio = Dividends per Share /  Earnings per Share

A third way you can calculate the dividend payout ratio is by using the retention ratio. The retention ratio is the opposite of the dividend payout ratio. It is a measure of how much of a company’s earnings it doesn’t distribute as dividends but keeps for other uses.

The resulting formula to calculate the dividend payout ratio is this:

Dividend Payout Ratio = 1 – Retention Ratio

So if the company retains 70% of its earnings, then the dividend payout ratio = 1 – 70% = 30%.

## Example

Let’s say a company has earned \$20 million for the year. Over that same time period, the company has issued \$4 million in dividends. You would calculate the dividend payout ratio as follows:

DPR = \$4 million / \$20 million = 20%

If the company has 20 million shares outstanding, then the company has earned \$1 per share. And if the company issues \$4 million in dividends, then dividing that by 20 million shares = 20 cents per share.

DPR = \$0.20 / \$1 = 20%

Finally, if a company pays out 20% of its dividends, that means its retention ratio is 80%. Because 80% of its earnings have been retained. So you can also calculate DPR as follows:

DPR = 1 – retention ratio = 1 – 80% = 20%

## How to Interpret the Dividend Payout Ratio

So what counts as a good dividend payout ratio? That is dependent on the industry the company is in and its stage of maturity.

For example, let’s say “Acme Tech” is a high-growth tech company that is still relatively young in its life cycle. The company pays very low or even no dividends. Is that bad?

Probably not, because the company still has a lot of growing. Using its earnings for growth projects and investment rather than paying out dividends makes a lot of sense in this instance.

But then take a company like Pepsi. This is no longer a high-growth company and it’s been around for quite awhile. A shareholder would expect a company like Pepsi to pay them a significant dividend as part of their investment.

Even Apple started paying out dividends in 2012. This means that rapid share price appreciation is less likely.

Whether a dividend payout ratio is good is relative to an investor’s investment goals. If you’re mostly a growth investor looking for large amounts of capital appreciation, you will want to look for stocks with lower payout ratios. On the other hand, if you’re primarily looking to generate high dividend yields from your investments as an income investor, you’ll want to look for stocks with large payout ratios.

## Dividend Sustainability / Safety

One thing investors should be concerned about is the sustainability or safety of the quarterly dividend payment of a stock. Ideally, you want to see perpetual dividend growth. But at the very least, you want the dividend to remain stable over time.

Cuts in a dividend are usually a bad sign and the markets tend to react accordingly. Companies are therefore reluctant to cut dividends.

So it’s important to keep an eye on the dividend payout ratio. A DPR of over 100% is a major red flag because it means that the firm is paying out more in dividends than it is taking in as earnings.

This is not a sustainable model over the long term. So it will generally mean that a cut in the dividend payment is on the way. The company may even stop paying its dividend altogether. This will usually negatively affect the price of the stock.

So long-term trends in payout ratio matter. Steadily rising dividends can often be interpreted as healthy growth. But a spiking payout could mean the company is heading toward unsustainability and danger lies ahead.

Investment U often evaluates the dividend safety of various dividend paying stocks. Here are a few of our most recent analyses:

## Industry

Payout ratios also tend to vary by industry. It is more useful to compare a stock’s DPR to other companies in its own industry than to the market at large.

For example, Real Estate Investment Trusts (REITs) are legally obligated to distribute at least 90% of their earnings as dividend payouts. Master Limited Partnerships (MLPs) also tend to have higher payouts. Meanwhile, a high-growth industry like biotechnology may have far lower dividend payout ratios than the market average.

## Augmented Payout Ratio

There are other ways that a company may return value to shareholders besides paying out dividends. One way a company can do this is by buying back shares of stock, which essentially distributes that cash paid out to shareholders.

There is a formula called the Augmented Payout Ratio that takes share buybacks into account. This formula can be calculated as follows:

Augmented Dividend Payout Ratio = (Dividends Paid + Total Share Buybacks) / Net Income

Very high augmented DPRs can mean too many short-term cash payments and not enough focus on long-term investment and growth. This could be a harbinger of bad things for a company’s future. On the other hand, if the augmented DPR is too low, the company may not be distributing enough of its earnings back to its shareholders. And this can ruffle their feathers.

## Payout Ratio vs. Dividend Yield

Sometimes there is some confusion between the dividend payout ratio and the dividend yield. Whereas the payout ratio refers to the amount of money paid out relative to net earnings, the dividend yield is the amount paid out relative to the current stock price.

Another way of putting this is that the dividend yield is the simple rate of return (in terms of dividends) for shareholders. The dividend yield can be measured accordingly:

Dividend Yield = Annual Dividends per Share  / Current Share Price

While the dividend yield can be useful information in evaluating your potential return on a stock purchase, dividend payout ratio is perhaps a better indicator of how dividends will continue to be paid out in the future.

## Concluding Thoughts on the Dividend Payout Ratio

When a company raises its dividend, just as Chevron and Standard Motor recently have, it’s often a sign of good financial health. And the dividend payout ratio is another smart way to evaluate the health and sustainability of a company’s dividend payments and its overall business strategy.

If you’re interested in learning more about how to make a killing by investing in dividend stocks, make sure to subscribe to Investment U’s daily e-letter by entering your email address in the field below. Our dividend and income stock expert Marc Lichentenfeld can help you take your dividend investing to the next level.