Being able to tell how well a company is performing before or after investing money is incredibly important. If you plan to buy or currently own dividend-paying stocks, that’s not the only metric you need to keep tabs on. The dividend yield is a good indicator as to how good the payments are, but the payout ratio is how you can tell whether a company can actually afford the said dividends.
What is the dividend payout ratio?
The dividend payout is a representation of the earnings paid out as dividends to shareholders, compared against income saved for the company. This metric is represented as a percentage with 100% being the company’s earnings fully sent out to shareholders. Any higher than that is not a good way to run a business, for sure.
The earnings reserved for dividends is paid out to shareholders on a regular basis and is decided by the board. If a company pays out all of its earnings to those who hold shares, there isn’t much left to reinvest into the company for expansion. This, of course, depends on how the company in question is positioned.
A newer company looking to expand, research, and develop new products and servers may want to hold back most (if not all) earnings and pay next to nothing in dividends. A more mature company with an established foundation to rely on may have more room to wiggle and pay a higher percentage of its earnings to shareholders.
How to calculate the dividend payout ratio
Calculating the dividend payout is pretty easy. All you need is the company’s net income and the reported dividend payout.
Dividend payout ÷ Net income = Dividend payout ratio
Convert the result into a percentage and you have your dividend payout. Ideally, you’ll want to keep it below 100%. As aforementioned, the ideal dividend payout percentage for a company depends on how it operates. A real estate investment trust (REIT) like Realty Income (O) will have a higher dividend payout than other companies simply because that’s how it’s structured.
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The dividend payout ratio is a good indicator of how a company is managing its finances in regards to dividend payouts. If you’re looking to (or already are) investing in a company that has a dividend payout ratio of beyond 100%, you can look to expect a dividend cut at some point in the future to bring it within a sustainable range.