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What is a Payout Ratio?
One of the factors to consider when investing in stocks is whether a company you invest in pays a dividend or not. A dividend is when a part of the company's earnings are given back to the shareholders, depending on how many shares they own. Usually, not all the earnings are given back, but rather just a percentage of them. This percentage is what the payout ratio consists of. It is calculated as the yearly dividend paid per share, divided by the earnings per share during the same year.
A payout ratio is written in percentages. If the ratio is 0%, this means there is no dividend paid to the shareholders. Many stocks do not pay yearly dividends, so a ratio of 0 is not uncommon. A 100% payout ratio means that all the company's earnings are given to the shareholders, who are technically the company's owners. A relatively high payout ratio may indicate that little or no expansion is to be expected from the company in the near future.
There is nothing wrong with a high payout ratio. It may mean nothing more than that a higher return would be gained from shareholders investing dividends on their own, rather than the company investing more of their earnings. In some cases, the ratio may exceed 100%. While this can be a profitable situation in the short term for investors, it is not a sustainable condition.
One time when this high of a ratio might be seen is in an environment of economic pessimism or slowdown. A company may temporarily increase its dividend and payout ratio to keep the stock attractive — and its price stable — because any other course might prove damaging to the price of the stock. A dividend that stays above 100% of the company's earnings is generally not seen as a good long-term sign for the company.
Many financial advisors counsel that the most ideal payout ratio is between 40 and 60%. This allows the investor to collect a good periodic income from dividends, if their holdings are substantial. It also means that the company has in mind the importance of continued growth, in the near term as well as the more distant future. Most balanced portfolios will contain some dividend-paying stocks, both as a way to increase the portfolio's income in the short term, and to help it beat inflation in the long run.
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Discussion Comments
@hamje32 - I think that’s the average payout ratio for most companies nowadays.
One thing that should be pointed out is that payout ratios for those same companies can increase over time. They may start out low because they are using most of their profits to reinvest in the business, but as the company grows, it can afford to increase its payout ratio.
Eventually it reaches a plateau, like the article says, and can give you close to 100% dividend payout ratio. Whether that’s a good or bad thing, you’ll have to decide. But it’s nice to have stocks that pay something regardless of the performance of their share price.
My dad invested in stocks in his day, and he never invested in a stock that didn’t pay dividends.
To that end, he looked for companies that offered stability and proof that they were in it for the long haul, which meant of course a lot of the blue chip stocks.
I think dividends and high payout ratios are good, but when I got into Internet investing during the “bubble” of the late 1990s, I didn’t pay any attention to dividends.
Most of the so-called “dot coms” didn’t pay dividends anyway. They rewarded shareholders with rapid stock appreciation, and windfalls from stock splits. That was before the bottom fell out of the market.
Today, I am a little wiser, and I try to balance out my portfolio with dividend paying stocks. Most of them have a dividend payout ratio of 30%, which is fine with me.
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