Dividend stocks can be a great way to generate passive income. The best ones consistently increase their dividends per share each year.
However, not all companies can routinely increase their dividends. One differentiating factor is the dividend payout ratio. Here's a closer look at this crucial metric fordividend investing.
Image source: The Motley Fool.
Formula
Dividend payout ratio formula
A company's dividend payout ratio is the percentage of that company's earnings that it pays out to its investors as dividend income. The dividend payout ratio formula is:
Total Annual Dividend Payments ÷ Annual Earnings = Dividend Payout Ratio
Say a company earns $100 million this year and makes $50 million in dividend payments to its shareholders. In this case, its dividend payout ratio would be 50%.You can also use per-share amounts to get the same result. This can be simpler since companies report dividends and earnings in per-share amounts.
Example
Example of how to use the dividend payout ratio
Let's use Apple (AAPL 0.93%) to demonstrate how to calculate the dividend payout ratio using per-share information. As of July 1, 2023, Apple had earned $5.95 per share over the previous four quarters. Its most recent quarterly dividend was $0.24 per share, which works out to $0.96 per share annually. Using the dividend payout ratio formula above, we have:
$0.96 Annual Dividend Payments ÷ $5.95 Earnings Per Share = 16% Dividend Payout Ratio
A good dividend payout ratio
What is a good dividend payout ratio?
Dividend payout ratios tend to vary by industry. Companies that operate in mature, slower-growing sectors that generate lots of relatively steady cash flow may have higher dividend payout ratios. They don't need to retain as much money to fund their business for things like opening new stores, building another factory, or on research and development for new products. For financially strong companies in these industries, a good dividend payout ratio may approach 75% (or higher in some cases) of their earnings.
However, companies in fast-growing sectors or those with more volatile cash flows and weaker balance sheets need to retain more of their earnings. Ideally, it should be less than 50%.
A safe dividend payout ratio
What is a safe dividend payout ratio?
When you calculate dividends, you'll also want to calculate the dividend payout ratio. A safe dividend payout ratio varies by industry and a company's overall financial profile. For example, one company operating in a stable sector might safely maintain a high dividend payout ratio of 75% of its earnings because it has a strong balance sheet. On the other hand, a competitor in that same industry that has a weaker financial profile might not be able to sustain its dividend if it had a payout ratio that high.
Historically, the safest dividend payout ratio has been around 41%, according to research by Wellington Management and Hartford Funds. Moredividend stockswith a payout ratio averaging around that level have outperformed exchange-traded funds (ETFs) that track the S&P 500 than those with other payout levels. That's because they can pay an attractivedividend yield while also retaining a significant amount of cash to expand their business. They can also use it on other shareholder-friendly activities such as share repurchasesand debt repayment.
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Dividends Per Share
The dividends a company pays out per share and a commonly used per-share metric.
Is a high payout ratio good?
Is a high dividend payout ratio good?
A mistake many beginning investors make is to buy stocks with the highest dividend yields they can find. They assume that the higher yield will enable them to earn greater returns.
Unfortunately, that's not always the case. Many stocks with high yields also have a high dividend payout ratio. That potentially puts them at risk of cutting the dividend if business conditions deteriorate. They're also less likely to increase the amount of dividends paid since they have lower retained earnings. That gives them less wiggle room to increase their payout ratio.
A better approach is to buy stocks with a lower payout ratio, even if it means sacrificing potential yield to ensure that you own companies that can continue to pay dividends. These companies have more financial flexibility to invest in expanding their earnings, which will enable them to increase their dividends.
This is evident in the historical performance of dividend stocks:
Data source: Ned Davis Research and Hartford Funds.| Grouping | Annual Average Returns (1973-2022) |
|---|
| Dividend growers and initiators | 10.24% |
| Equal-weighed S&P 500 Index | 7.68% |
| No change in dividend policy | 6.6% |
| Dividend cutters and eliminators | 3.95% |
As the table shows, companies that made no change to their dividend policy (i.e., they maintained their payout level) and those that either cut or eliminated their dividends have underperformed the S&P 500 over the past several decades.
On the other hand, companies that recently initiated a dividend and those that have consistently increased their dividends -- such as Dividend Achievers andDividend Kings-- have outperformed the over the long term. That's why investors should seek out companies with a lower dividend payout ratio instead of a higher yield since they're more likely to increase their payouts.
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Don't overlook the dividend payout ratio
The dividend payout ratio is a vital metric for dividend investors. It shows how much of a company's income it pays out to investors. The higher that number, the less cash a company retains to expand its business and its dividend.
Given the significant outperformance of dividend growth stocks, investors can use the dividend payout ratio to find companies with the flexibility to routinely reward them with more dividend income in the future.
Jason Hall has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple. The Motley Fool has a disclosure policy.
FAQs
So, what counts as a “good” dividend payout ratio? Generally speaking, a dividend payout ratio of 30-50% is considered healthy, while anything over 50% could be unsustainable.
What is the dividend payout ratio in simple words? ›
What Is a Dividend Payout Ratio? The dividend payout ratio is the total amount of dividends that a company pays to shareholders relative to its net income. Put simply, this ratio is the percentage of earnings paid to shareholders via dividends.
What are the 4 ratios to evaluate dividend stocks? ›
The four most popular ratios are the dividend payout ratio, dividend coverage ratio, free cash flow to equity, and Net Debt to EBITDA.
What is a good dividend coverage ratio? ›
Generally speaking, a DCR of 2 is viewed as good, as this indicates that a company has the capacity to pay its dividends twice over. A DCR of below 1.5 is viewed as a possible concern, signalling the use of loans.
What is a good dividend payout ratio for a REIT? ›
Real estate investment trusts (REITs) are required to pay out at least 90% of income as shareholder dividends. Book value ratios are useless for REITs. Instead, calculations such as net asset value are better metrics. Top-down and bottom-up analyses should be used for REITs.
What is a healthy dividend payout? ›
Healthy. A range of 35% to 55% is considered healthy and appropriate from a dividend investor's point of view. A company that is likely to distribute roughly half of its earnings as dividends means that the company is well established and a leader in its industry.
What is too high for a dividend payout? ›
A low payout ratio can signal that a company is reinvesting the bulk of its earnings into expanding operations. A payout ratio over 100% indicates that the company is paying out more in dividends than its earnings can support and this could be an unsustainable practice.
What does a 50% dividend payout ratio mean? ›
Say a company earns $100 million this year and makes $50 million in dividend payments to its shareholders. In this case, its dividend payout ratio would be 50%. You can also use per-share amounts to get the same result. This can be simpler since companies report dividends and earnings in per-share amounts.
What is considered a good dividend yield? ›
Yields from 2% to 6% are generally considered to be a good dividend yield, but there are plenty of factors to consider when deciding if a stock's yield makes it a good investment. Your own investment goals should also play a big role in deciding what a good dividend yield is for you.
What is a low dividend payout ratio? ›
A low dividend payout is when a company keeps the majority of its profits and reinvests it in the business and then gives out the rest as dividends. For example, if a company reinvests 60% of its profits back into the business and then pays out the rest in dividends, it has a dividend payout of 40%.
Stable Dividend
In this pattern, shareholders receive a fixed dividend amount occasionally. This stability in distributing dividends is unaffected by the earnings of the company. With this dividend policy, the company pays shareholders a dividend even if they are making losses.
How to tell if a dividend is safe? ›
Three signs of a safe dividend
- An economic moat. An economic moat, which encapsulates a company's competitive advantage, is one of the best tools to identify the stability of a company's profit stream. ...
- Strong finances. ...
- Balanced payout ratios.
Evaluating the stability of dividends is crucial for investors before making any investment decisions. Investors can use several metrics, including dividend yield, dividend payout ratio, dividend history, earnings growth, and free cash flow, to evaluate dividend stability.
What is the preferred dividend payout ratio? ›
The dividend payout ratio is the measure of dividends paid out to shareholders relative to the company's net income. A preferred dividend is one that is accrued and paid on a company's preferred shares. Their dividend payments take preference over common shares.
What is the optimal dividend payout policy? ›
The optimal dividend policy is simple: only distribute dividends when cash holdings exceed threshold , which depends on the state of the economy. This is done exactly as in the deterministic interest rate case. Namely, if the initial cash holdings exceed , then an initial dividend of x − x ( i ) is distributed.
What is the difference between dividend yield and payout ratio? ›
Dividend Yield: Dividend yield measures the income investors earn for every dollar they invest. It's calculated by dividing the annual dividend per share by the stock's current price. Dividend Payout Ratio: Dividend payout ratio measures how much of a company's earnings are paid out to its investors.
What is a good dividend payout ratio? ›
A 40% payout ratio would be favorable for an investor because a payout ratio below 50% gives a company enough flexibility to reward shareholders while reinvesting in new projects. Some profitable companies, such as Alphabet Inc.
What REITs pay the highest dividend? ›
The market's highest-yielding REITs
| Company (ticker symbol) | Sector | Dividend yield |
|---|
| KKR Real Estate Finance Trust (KREF) | Mortgage | 14.0% |
| Two Harbors Investment (TWO) | Mortgage | 14.0% |
| Ares Commercial Real Estate (ACRE) | Mortgage | 13.8% |
| Brandywine Realty Trust (BDN) | Office | 13.6% |
7 more rowsFeb 28, 2024
To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.
What is a good stock dividend payout? ›
Yields from 2% to 6% are generally considered to be a good dividend yield, but there are plenty of factors to consider when deciding if a stock's yield makes it a good investment. Your own investment goals should also play a big role in deciding what a good dividend yield is for you.
$4 annual dividend per share / $10 EPS = 40%
A 40% payout ratio would be favorable for an investor because a payout ratio below 50% gives a company enough flexibility to reward shareholders while reinvesting in new projects. Some profitable companies, such as Alphabet Inc.
