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Dividend Payout Ratio: Definition, Formula & Analysis

Instructor
Sarah Bilant

Sarah has taught QuickBooks classes, has a Bachelor of Science degree in Accounting, and is a licensed CPA.

Expert Contributor
Steven Scalia

Steven completed a Graduate Degree is Chartered Accountancy at Concordia University. He has performed as Teacher's Assistant and Assistant Lecturer in University.

Company shareholders invest their money in corporations by purchasing shares of a corporation's stock in exchange for a percentage of ownership, as well as dividend payouts. Learn what dividends are, how to calculate the dividend payout ratio, and analyze the results in this lesson. Updated: 05/07/2020

Corporations, Shareholders, and Dividends

A corporation is a business that issues shares of stock in exchange for ownership in the corporation. The purchasers of the stock are called shareholders. A corporation can have different types of stock, such as preferred stock and common stock, which give shareholders different rights. As the name suggests, preferred stockholders are given priority over common stockholders to dividends and a corporation's assets in the event of a bankruptcy.

The decision to invest in a corporation is typically made by determining whether or not the investor, or shareholder, believes the share price will increase in the future and whether or not the corporation is likely to pay dividends. A dividend is a distribution of a corporation's earnings to its shareholders. In general, dividends are paid at a specific rate per share to shareholders who owned stock as of a certain date, and are not guaranteed.

The dividend payout ratio is a financial measure that determines the percentage of earnings that have been paid out to shareholders as dividends, if any. The ratio is used to help investors establish how dividends were paid in the past to predict how dividends will be paid in the future. The result of the calculation allows investors to make informed investment decisions.

Calculation and Analysis

The dividend payout ratio can be calculated in one of two ways: on an individual share basis or on a total share basis. Both formulas end in the same result, so the formula used is determined by what information the investor has access to. To calculate on an individual share basis, the earnings per share ratio for the period must first be calculated.

Earnings per Share = (Net Income after Tax - Preferred Stock Dividends) ÷ Average Number of Common Shares Outstanding

The annual dividend paid per share is divided by the earnings per share ratio to obtain the dividend payout ratio.

Dividend Payout Ratio = Annual Dividend Paid per Share ÷ Earnings per Share

To calculate on a total share basis, total dividends paid for the period is divided by net income for the period.

Dividend Payout Ratio = Total Dividends Paid ÷ Net Income

The dividend payout ratio is presented as a percentage and can be positive or negative. The ratio will generally be positive, but can be negative if the corporation elects to pay a dividend out of prior earnings in a year when a net loss is incurred. The ratio itself must be analyzed by taking outside factors into account, as the results can have multiple meanings depending on the corporation's specific circumstances. A zero or low ratio may mean that the corporation is using all of its available funds to grow the business, or it may mean that the corporation does not have earnings to distribute. On the other hand, a ratio that nears or exceeds 100% may mean that the corporation is using cash reserves to pay dividends and may not be adequately investing earnings back into the business.

Examples

Now let's look at a couple of examples.

Example 1

Elizabeth is considering investing in Cherry Water Company and has asked you to calculate the dividend payout ratios. Cherry Water Company has had 10,000 shares of common stock outstanding since its start and no shares of preferred stock. The corporation has been in business for three years and is growing steadily. The corporation has recorded net income of $100,000, $500,000, and $1,000,000 at the end of each of the three years, respectively. Dividends have been paid as follows:

Year 1: $0.50 per share

Year 2: $4.00 per share

Year 3: $10.00 per share

Per Share Calculation

Using the formula to calculate on a per share basis, we would first calculate the earnings per share ratio for each of the years, then divide the annual dividend paid per share by the result:

Year 1:

($100,000 Net Income - $0 Preferred Dividends) ÷ 10,000 Common Shares Outstanding = $10 Earnings per Share

$0.50 Dividend per Share ÷ $10 Earnings per Share = 5% Dividend Payout

Year 2:

($500,000 Net Income - $0 Preferred Dividends) ÷ 10,000 Common Shares Outstanding = $50 Earnings per Share

$4.00 Dividend per Share ÷ $50 Earnings per Share = 8% Dividend Payout

Year 3:

($1,000,000 Net Income - $0 Preferred Dividends) ÷ 10,000 Common Shares Outstanding = $100 Earnings per Share

$10.00 Dividend per Share ÷ $100 Earnings per Share = 10% Dividend Payout

Total Share Calculation

Alternatively, we can get the same results by using the formula to calculate on a total share basis. To calculate the ratio for each of the years, we must divide total dividends paid for the year by net income. Total dividends paid can be calculated by multiplying the dividend per share by the number of shares outstanding.

Year 1:

($0.50 Dividend per Share x 10,000 Common Shares Outstanding) ÷ $100,000 Net Income = 5% Dividend Payout

Year 2:

($4.00 Dividend per Share x 10,000 Common Shares Outstanding) ÷ $500,000 Net Income = 8% Dividend Payout

Year 3:

($10.00 Dividend per Share x 10,000 Common Shares Outstanding) ÷ $1,000,000 Net Income = 10% Dividend Payout

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Additional Activities

Dividend Payout Ratio - A Practical Exercise:

The following exercise is designed to allow students to apply their knowledge in the calculation and interpretation of the Dividend Payout Ratio.

Context:

You are a portfolio manager at Bam Bam Investments Inc, an investment management company that is located in New York. You manage the company's High Dividend Yield Fund, a fund that is designed to provide regular returns to investors through quarterly dividend payments. Every year, your team looks over various investment opportunities in order to ensure that your clients obtain the best possible opportunities to maximize their return.

Your team of analysts have found three potential investments that you do not currently own in your portfolio. You can only add one of these securities to your portfolio since your available capital is limited. Each of these companies has a long-standing history of paying out dividends and their dividends have remained stable in recent years. You are presented with the following data:

CompanyABC
Net income ($)10,000,00025,000,00040,000,000
Common dividends in current year ($)3,500,0005,000,00010,000,000

Your intern says that the best investment is Company C since its net income is the highest. However, you want to determine which company rewards shareholders the most based on the income it earns.

Required:

  1. Calculate the dividend payout ratio for each company.
  2. Using your results, identify which company rewards its shareholders the most based on its income? Why?

Solution:

1. Dividend payout ratio

Company A:

= 3,500,000 / 10,000,000 = 35%

Company B:

= 5,000,000 / 25,000,000 = 20%

Company C:

= 10,000,000 / 40,000,000 = 25%

2. The answer is Company A because it has the highest dividend payout ratio. This means that Company A has sufficient funds and liquidity to pay out a higher percentage of its earnings as dividends compared to the other companies.

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