Before purchasing a specific company’s stock, investors often take into account factors like market capitalization, investment income potential and forecasts for future growth. One other element to consider is the dividend payout ratio or DPR. Here’s what to know about this metric and how it affects a company’s finances and, potentially, an investor’s.
What’s a dividend payout ratio?
dividend payout ratio or DPR tells an investor what percentage of earnings a specific company paid out to shareholders in the form of a dividend, which is a periodic payout of earnings that some companies and funds share with investors.
This is important because a company that is paying out a large proportion of its earnings is then not using it for other purposes, like paying down debt or plowing it back into the company to fund research and development, operations, marketing, sales or any other potential growth activity.
While the DPR doesn’t tell you specifics about a company’s health per se, it gives you insight into a company’s priorities. You can determine whether they are more focused on sharing their wealth with owners or shareholders or reinvesting the gains for potential future growth.
How do you calculate a dividend payout ratio?
The good news is that you don’t have to be a math whiz to determine this number. All you need to know are the dividends per share, which you’ll divide by the company’s earnings per share.
The formula looks like this:
Dividends Per Share divided by Earnings Per Share equals Dividend Payout Ratio or more simply:
DPS➗EPS = DPR.
So let’s put that math into practice. Let’s say you’re looking at a stock that offers a dividend per share (DPS) of $2 and earnings per share (EPS) of $5. Using our formula, the DPR would be 40 percent.
The DPR can range from 0 percent—a company that isn’t paying out any dividends—to 100 percent or more, which as we’ll see below, might not be ideal.
What is a good dividend payout ratio?
The real question is whether a certain DPR is considered good or bad. After all, if we look at our example above, a 40 percent raise would be fantastic, but a 40 percent loss in your stock account would be frightening.
As with many investing questions, the answer when trying to determine a good DPR is: It depends. Some of the factors to take into account in your interpretation are:
Is the company mature or still growing?
An organization that’s in growth mode should ideally be prioritizing investing its profits back into the company. That means that if you’re a more aggressive investor, you’re likely to see a lower DPR as a benefit, since you would prefer that a start-up or growing company focus on keeping that expansion coming by developing new products or entering new markets.
In the longer run, ideally that will fuel an increase in the stock price, as well as the potential for a larger payout to shareholders in the future. In this case, they should be offering little to no dividend today.
By contrast, a company in a more mature industry might not have as many investment opportunities, and instead may be rewarding shareholders with that higher DPR. Often you’ll find this behavior from blue-chip stocks, which are stocks of a reputable company that is a leader in its industry.
However, it’s important to note that a mature company with a lower DPR might have another motive. For example, it could be diversifying into a new sector or product line and needs to channel funds toward that opportunity.
Is this DPR sustainable?
Of course, we know that you can never predict exactly what a company is going to do. But if an organization is offering a historically large dividend, you might want to look into why. Is this a potential roadmap for the future (and thus perhaps an enticing carrot to become a shareholder)? Or could an unusually large DPR be offering a warning? It could be they are trying to shore up support and placate shareholders with one particularly big payday.
That’s why it’s important to take a look back at DPR trends to try to identify the motivation. For example, if you see that DPRs have been steadily rising over the past few years, you can gather that the company is in a healthy place where it believes it’s hitting that “maturity” level where aggressive investment isn’t as key, and the goal now is to reward shareholders.
Does the DPR indicate future problems?
While a small or even non-existent DPR isn’t a problem for a company in growth mode, an outsized DPR (100 percent or more) could be portending financial trouble. That’s because it means the organization is paying out more than it’s taking in, which obviously is not sustainable. In that case the firm could be in financial straits and trying to keep its shareholders from jumping ship. That’s fine if you’re already on the boat and want to enjoy that largesse, but otherwise, it’s probably not a ship you’d want to board.
What’s a typical DPR for this industry?
While there are outliers in any industry, it can be useful to consider conventional behavior for a specific industry as another piece to the puzzle. For example, tech companies that are constantly innovating are less likely to offer dividends than more mature industries like utilities or telecom.
What are my investing goals?
Many investors with a long-term horizon and a more aggressive outlook might prefer a stock with a low DPR because it indicates the company is reinvesting and therefore will potentially offer attractive stock growth if you maintain your shares. Conversely, a more conservative investor might prefer getting some of their investment back every year in the form of income, rather than relying on stock growth to meet their financial goals.
What’s the difference between dividend payout ratio and dividend yield?
As you’re researching the DPR, you might also run across the term “dividend yield.” While both are expressed as percentages, here’s the difference: While the DPR tells how much of a company’s net earnings are disbursed as dividends, the yield tells you how much a company has paid out over the course of the year, to see how much return per dollar invested the shareholder is receiving.
The formula looks like this:
Annual Dividends Per Share ➗Price Per Share = Dividend Yield.
So for example, a stock that paid out $5 in annual dividends per share that is trading at $100 has a dividend yield of $20.
And while dividend yield is the metric that investors often consider more closely, some believe that the DPR provides a better indicator of how well a company is equipped to distribute dividends in the future because it is more closely connected to a company’s cash flow.
As always, remember that there are no clear-cut answers as to what’s the “right” investment strategy, asset class or even dividend payout ratio. The answers will depend on your personal investment goals, risk tolerance and time horizon.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.