Investors seeking income look for shares that pay generous dividends and which hopefully increase their dividends each year. Here we look at the dividend payout ratio, how to calculate it, and what different dividend payout ratios mean.
Understanding the dividend payout ratio
A dividend payout ratio is the ratio of dividends paid to shareholders relative to a company's net income. It measures the percentage of net income paid out to shareholders as dividends.
A higher dividend payout ratio means a company pays more earnings to shareholders. A lower dividend payout ratio means the company retains more earnings. It can use retained earnings to reinvest in the business to fuel growth or pay down debt, which can benefit shareholders.
Dividend payout ratios matter because they indicate how companies are using their earnings. Companies seeking to grow aggressively will likely reinvest more money into the business. This usually means lower dividend payments and a lower dividend payout ratio.
These companies can be attractive to growth investors, but investors seeking a steady income stream will likely prefer companies with a high dividend payout ratio. Companies with a high dividend payout ratio are likely to be more mature and generate relatively steady cash flows.
How does a dividend payout ratio work?
A company's dividend payout ratio is calculated by dividing the total dividends paid in a year by its total net income received. The formula is:
Dividend payout ratio = total dividends ÷ total net income
For example, if Company A received a net income of $100,000 in a year and paid out dividends of $50,000, its dividend payout ratio would be 50%. If Company B received a net income of $100,000 in a year and paid dividends of $20,000, its dividend payout ratio would be 20%.
Companies must balance paying earnings to shareholders and retaining earnings to reinvest in the business. The ideal balance will vary across companies but should allow them to keep sufficient cash to maintain balance sheet strength and expand as opportunities arise. Retained earnings can also be used to pay down debt or return funds to shareholders via share buybacks.
What is a high or low dividend payout ratio?
Dividend payout ratios vary across companies and industries. Companies operating in mature industries that receive steady cash flows can afford to pay out more of their earnings in dividends. For these companies, a dividend payout ratio of 75% or less is reasonable.
Companies in fast-growing sectors or with more volatile cash flows will generally pay less in dividends. This is because funds are needed to fuel expansion and maintain balance sheet strength. A dividend payout ratio of below 50% should be expected for these companies.
What is considered a safe dividend payout ratio varies across companies and industries. For example, companies in the technology sector tend to have lower dividend payout ratios compared to utility companies.
The dividend payout ratio will depend on a company's overall financial profile and the nature of earnings in its industry. Two companies operating in the same industry may have different dividend payout ratios due to differences in their financial strength.
A company with a strong balance sheet can afford to pay out a higher proportion of earnings as dividends than companies with weaker financial profiles.
What does a company's payout ratio indicate?
A company's dividend payout ratio can indicate how well it is doing financially. One of the purposes of a company is to maximise shareholder wealth. Companies take money from shareholders to finance their operations. When they make a profit, the company must share this with shareholders.
This does not mean shareholders will receive 100% of the profits. Companies must retain some cash to reinvest in continued growth and expansion. There is an opportunity cost to paying dividends in that money distributed as dividends cannot be invested in something else.
How much a company chooses to pay shareholders and how much it decides to retain will depend on its maturity, growth opportunities, and track record of paying dividends.
Maturity: Companies that are new to the market and have a growth orientation will generally prefer to reinvest earnings into expansion. To be able to pay dividends, these companies need to grow beyond the initial stages of business. Many high-growth companies choose not to pay dividends at all.
For example, look at Xero Limited (ASX: XRO). Xero has reported significant increases in revenue over the past few years but has not paid dividends to shareholders. This is because the company is still in its growth phase, so management thinks there is better value in reinvesting its cash into the business than distributing it to shareholders.
Reinvestment opportunities: Even well-established companies may choose not to pay high dividends to shareholders if they have many opportunities to reinvest earnings. The idea is that the reinvestment will allow them to grow profits at an increased rate, ultimately benefiting shareholders down the line.
Track record: Companies with a strong track record of paying dividends can come under pressure from shareholders to grow (or maintain) dividend levels. Growing dividends over time indicate that a company is financially healthy and generating increased revenue.
This ensures the company remains attractive to investors. Many large ASX-listed companies have a target dividend payout ratio that they aim to meet. For example, the Commonwealth Bank of Australia (ASX: CBA) targets a dividend payout ratio of 70% – 80%, while AGL Energy Limited (ASX: AGL) targets a dividend payout ratio of 75%.
Why would a company change its payout ratio?
Dividend payout ratios can change over time as companies mature and the economy moves through different phases of the economic cycle. When the COVID-19 pandemic hit, many companies slashed dividends to preserve a capital buffer.
CBA cut its half-year dividend from $2.31 in 2019 to 98 cents in 2020. As the pandemic receded and the economic recovery ebbed and flowed, so too have dividends. CBA's 2021 half-year dividend was back up $2.00 per share, its 2022 interim dividend slipped to $1.75 per share the upped to $2.10 per share in 2023.
By paying dividends, companies signal that their business is earning enough to share a portion of gains with shareholders. This can increase shareholder confidence in management and be a crucial factor in investing.
The dividend payout ratio can give investors an indication of which companies are most aligned with their investment goals. A company with a higher dividend payout ratio is likely to be more attractive if they seek a reliable income source.
On the other hand, investors looking for strong capital appreciation may be more willing to accept lower dividend payout ratios.