Dividend Payout Ratio, Powerful Metrics For Dividend Investors (Must Know)

Dividend paying companies are great companies to invest for building a passive dividend income stream.

As a dividend investor, we need to look into the various fundamentals of an investment and understand if the company is worth investing. One of such metrics is dividend payout ratio.

Dividend payout ratio can greatly impact the dividend yield you will be getting as an investor, a critical metrics for any dividend stocks.

If you want to become better in investing, let’s take a look at what is dividend payout ratio and how to use this to find great dividend paying stocks.

What is Dividend Payout Ratio?

The Dividend Payout Ratio is a crucial financial metric for performing fundamental analysis for any dividend paying stocks. The ratio indicates the proportion of a company’s earnings paid out to shareholders in the form of dividends.

The dividend payout ratio is expressed as a percentage, and it represents how much of the company’s profits are distributed to investors versus how much is retained (retention ratio) for reinvestment back into the company.

As a dividend investors, the payout ratio serves as a vital tool in evaluating the sustainability and attractiveness of a company’s dividend policy.

How to Calculate Dividend Payout Ratio

A Dividend Payout Ratio can be calculated using the financial data you get from the balance sheet of the company. The data you’ll need are:

• Dividend per Share
• Earnings per Share

Let’s break down the calculation of dividend payout ratio of a company step by step.

1. Find the Dividends per Share, which represents the total amount of dividends paid to shareholders divided by the number of outstanding shares.
2. Determine the Earnings per Share, which is the company’s net income divided by the number of outstanding shares.
3. Divide the Dividends per Share by the Earnings per Share, and multiply the result by 100 to get the percentage.

Dividend Payout Ratio Formula

The formula to calculate the dividend payout ratio is:

Dividend Payout Ratio = (Dividends per Share / Earnings per Share) x 100

Represented in percentage (%), the dividend payout ratio is the percentage of dividend company paid to it’s shareholders.

Interpreting Dividend Payout Ratio

Dividend payout ratio represents how much of the company’s free cash flow is distributed to the company’s shareholders as a dividend, and getting an understanding of what a dividend payout ratio mean can help you in making sound investment decision.

What Does High Dividend Payout Ratio Mean?

A high Dividend Payout Ratio indicates that a significant portion of the company’s earnings is being distributed to shareholders as dividends.

In most cases, this may be seen as favorable by dividend investors who value regular dividend income.

However, a high dividend payout ratio would also means that the company will have less free cash flow to grow their business. and less room for dividend growth unless the company grow in the future.

What Does Low Dividend Payout Ratio Mean?

A low ratio implies that the company is retaining a larger portion of its earnings for growth, expansion, or other financial commitments.

While companies with lower dividend payout will mean the dividend investor will not be getting as much of income in the form of dividend. These companies may have the potential of increasing their share price due to company’s growth, where in turn lead to a dividend growth.

And since these companies have a low dividend payout ratio, they will have the option of increasing their dividend payout ratio or issue special dividend in the future.

Implications for Investors on Dividend Payout Ratio

For dividend investors, the Dividend Payout Ratio offers valuable insights. In general,

• A high ratio could signify a stable and mature company with steady cash flows, while
• A low ratio might suggest a growth-oriented company with reinvestment opportunities. 

Both scenarios have their merits, and investors should align their dividend strategies accordingly.

What Does a 50% Dividend Payout Ratio Mean?

A 50% Dividend Payout Ratio means that the company is distributing half of its earnings in the form of dividends back to it’s shareholders. Retaining 50% of it’s free cash flow to be reinvested back into the company.

This dividend payout ratio is common amount dividend paying companies, and it is generally considered as an balanced approach that may also indicate that the company aims to reward shareholders while also retaining enough capital to support future growth.

What Does a 100% Dividend Payout Ratio Mean?

A 100% Dividend Payout Ratio means that the company is distributing all of its earnings as dividends. Retaining none of it’s earning back into the company.

While this might seem attractive to income investors, it’s essential to consider the company’s sustainability in the long term.

More often than not, it is consider a “dividend trap” where the company “traps” the investor into thinking that the company is doing well, but in fact, the company no plans on how to grow the business or even a troubled business that is on the brink of making a lost.

A high payout ratio can leave little room for reinvestment of capital back into growing the company, or dealing with unexpected financial challenges that may eventually cause the downfall of the company.

What is a Good Dividend Payout Ratio?

Every investors have their own chain of thoughts on what is consider a good dividend payout ratio. But what it actually mean by having a good payout ratio will actually mean that the company,

• Pays a reasonable amount of dividend that rewards it’s shareholders
• Dividend paid is using the company’s free cashflow and not through debt financing and borrowing 
• Company retain enough of the capital to reinvest into the company for growth.

Good Dividend Payout Ratio Should be 30% to 50%

A good dividend payout ratio should be between 30% to 50% of the company’s free cash flow.

This range strikes a balance between rewarding shareholders and retaining earnings for growth, ensuring the company’s financial health remains intact even when faced with unseen events.

Dividend Payout Ratio Should Not Be More Than 80% Unless it is REITs

A payout ratio exceeding 80% is considered high-risk, as it leaves little margin for handling unforeseen circumstances.

Unless you are talking about Real Estate Investment Trusts (REITs) which by law it is required to distribute 90% of it’s free cash flow back to it’s shareholders as dividends, general dividend stocks should not have a payout ratio of more than 80%.

Benefit of a Good Dividend Payout Ratio

Companies with a well-managed dividend payout ratio can offer many benefits to investors and dividend investors:

• Create a positive perception of the company’s financial stability.
• Have potential of offering a higher dividend yield, which can boost shareholder confidence and positively impact the stock price.
• Have the resource required to business growth or to weather unforeseen black swan events.

What is a Bad Dividend Payout Ratio?

Bad divided payout ratio generally means that the company pay out too much of it’s free cashflow to it’s shareholders.

Bad Dividend Payout Ratio is Anything That is More Than 100%

A dividend payout ratio exceeding 100% indicates that the company is paying out more in dividends than its actual earnings.

The company basically borrow money so that they can pay their shareholders a dividend. Whatever borrowed needs to be repaid, this situation is unsustainable and can lead to financial trouble in the long run.

Risk of a Bad Dividend Payout Ratio

Companies with excessively high payout ratios might be forced to cut dividends in the future, leading to a drop in the stock price and disappointed investors.

At the worst case, the company leave little to no free cashflow for the company to weather any financial storm, and lead to the bankrupt or closure of the company losing investor’s money in the process.

A bad payout ratio raises concerns about the company’s financial health, thus when seeing a company with a bad dividend payout ratio, you need to be extra careful in investing.

Reasons Why Dividend Payout Ratio is Important for Dividend Investors

There are a few reasons why gaining a clear understanding of the dividend payout ratio is important.

• Serves as a measure of dividend sustainability.
• Help investors assess if a company can maintain its dividend payments in the future.
• Provides insights into a company’s financial health.
• Understand management’s approach to rewarding shareholders.
• Stable and appropriate payout ratio can attract income-seeking investors, leading to increased demand for the company’s stock.

By understanding the payout ratio, investors can compare different companies within the same industry and identify potential investment opportunities.

Factors Influencing Dividend Payout Ratio

Dividend payout ratio is affected by many factors. A normal dividend payout ratio offered by a certain industry may not be normal for the other. Investors can use the dividend payout ratio and dividend yield to gain a better understanding of a company.

Industry Norms and Expectations

Each industry has its own set of norms when it comes to dividend payout ratios.

• Mature and established industries may have higher payout ratios compared to more growth-oriented sectors.
• Low capital intensive industry may have higher dividend payout ratio than a high capital intensive industry.

Company’s Financial Goals

From the dividend payout ratio, we can understand more about the company’s long-term goals.

• Companies with expansion plans or significant capital requirements may choose to retain more earnings, resulting in a lower payout ratio.
• Conversely, companies with stable cash flows and limited growth opportunities may distribute more dividends.

Availability of Free Cash Flows

A company’s ability to generate free cash flows influences its capacity to pay dividends. When free cash flows are limited, the company may opt for a conservative payout ratio to avoid financial strain.

Limitations of Dividend Payout Ratio

Dividend payout ratio is a financial metrics that offers many insights, however it too have it’s own set of limitations and as a smart investor, knowing it’s limitations can help you have a clearer picture on the financials of the company.

Ignoring Capital Investment Needs

Dividend payout ratio measures the amount of free cash flow is distributed back to it’s shareholders.

• A high dividend payout ratio may not always be desired as it may hinder a company’s ability to invest in research, development, and capital projects essential for future growth.
• A lower dividend payout ratio may not be always good if the company is not able to better utilize the free cash flow to grow the company effectively. 

Unreliable During Economic Downturns

The dividend payout ratio may not accurately reflect a company’s health during economic downturns when earnings may be temporarily affected.

However, a high dividend payout ratio of more than 100% is almost always a bad sign.

Not Considering Share Repurchases

Share repurchase is always a good thing for current shareholders as it increase the value of each share you own.

Companies may choose to buy back shares, reducing the outstanding shares and affecting the dividend payout ratio as it is using it’s free cash flow to repurchase the company’s shares.

Dividend Payout Ratio is An Important Metric For Dividend Investors

As a dividend investor, understanding the Dividend Payout Ratio can be a game-changer in your investment strategy.

When investing in dividend paying stocks, this valuable metric offers a glimpse into the types of dividend, company’s dividend policy, sustainability, and financial health.

By considering a company’s dividend payout ratio along with other fundamental indicators, you can make more informed investment decisions and build a well-diversified portfolio that aligns with your financial goals.

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Debt-to-Equity Ratio (D/E) is the metric help us visualize how capital has been raised to finance the operation of the company. D/E Ratio is generally used to evaluate a company’s financial health. A higher number will mean the company is highly leverage, and a lower number will mean the company is less leveraged.

Another name for debt-to-equity ratio is risk ratio, or leverage ratio (“Gearing Ratio” for REITs).

Numbers to be considered in Debt-to-Equity Ratio are:

• Short Term Debt
• Long Term Debt
• Fixed Payment Obligations
• Total Liabilities
• Total Shareholders’ Equities

Debt-to-Equity Ratio is a relatively good measurement on the risk the company is taking to continue operation.

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The formula for Debt to Equity Ratio is calculated by dividing the total shareholders’ equity by the total liabilities.

Debt to Equity Ratio = Total Liabilities/ Total Shareholders’ Equities

or

Debt to Equity Ratio = (Short term debt + Long term debt + Fixed payment obligations) / Shareholders’ Equity

You can generally get these numbers from the balance sheet found in the annual financial report provided by the company.

How to interpret debt to equity ratio?

Debt to equity ratio tells you how much debt you have in compared to your equity. A ratio of less than 1.0 means that you have less debt than equity. A ratio of more than 1.0 means that you have more debt than equity.

Interpretation of the Debt-To-Equity ratio can vary between industry.

Some industry such as the automobile depends heavily on debt, while energy industry usually have lower level of debt.

What does a Debt-To-Equity Ratio of 0.5 mean?

Debt to equity ratio of 0.5 means the company uses twice as much of equity to drive growth of the company than it uses debt aka. “borrowed money”. The shareholders/ investors, therefore, own two-thirds of the company’s assets. With D/E of 0.5 or less, the company is generally able to survive any unforeseen black swan events.

What does a Debt-To-Equity Ratio of 1.0 mean?

Debt to equity ratio of 1.0 means the company uses just as much of equity to drive growth of the company as it uses debt aka. “borrowed money”. The shareholders/ investors, therefore, own half of the company’s assets. With D/E of 1.0, most company lies in this range.

What does a Debt-To-Equity Ratio of 1.5 mean?

Debt to equity ratio of 1.5 the company uses just thrice as much of debt aka. “borrowed money” to drive growth of the company as it uses equity. The shareholders/ investors, therefore, own a quarter of the company’s assets. With D/E of 1.5, the company is using a high level of debt to drive growth.

Editor’s Recommendation: Good Debt vs Bad Debt

[title text=”What is a Good Debt-To-Equity Ratio?” tag_name=”h2″]

A good debt-to-equity ratio vary between industry. But the general consensus is that, D/E should not be above the level of 2.0. While some industries which requires high level of fixed-assets such as; mining, manufacturing and transportation may have higher than 2.0. These are exception. Most companies will have a D/E ratio of less than 1.5.

General speaking, you will want a low D/E when compared with the other companies in the industry of those which are of the similar sector.

Average Debt to Equity Ratio by Industry

Ranking	Sector	D/E Ratio
1	Energy	0.46
2	Capital Goods	0.58
3	Healthcare	0.69
4	Consumer Discretionary	0.75
5	Technology	0.8
6	Basic Materials	0.83
7	Services	1.04
8	Consumer Non Cyclical	1.09
9	Retail	1.09
10	Conglomerates	1.17
11	Utilities	1.27
12	Financial	1.29
13	Transportation	2.79

Source: csimarket

A quick look at the data give us some interesting insight on the performance of different sectors:

• Industry standard debt to equity ratio is 1.0.
• Industry with lowest debt to equity ratio is Energy.
• Industry with highest debt to equity ratio is Transportation.

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Let’s use an example to understand the calculation of the Debt to Equity Ratio formula better.

Susan is a smart low-risk dividend investor who is thinking of investing at ABC Company.

Susan knows that if she do a proper fundamental analysis of the company, she can understand more about the financial health of the company.

Debt-To-Equity Ratio is just one of the many fundamental analysis numbers that Susan need to calculate. This number allows her to have a rough idea on how “risky” it will be to invest into ABC company.

The company has provided the following information in the website:

Information Provided
Short Terms Debt	$500
Long Term Debt	$1,000
Fixed Payment Obligations	$500
Shareholders’ Equity	$1,000

What is the Debt to Equity Ratio of the Company?

Debt-to-Equity Ratio is calculated by using the formula given below:

Debt-to-Equity Ratio = (Short term debt + Long term debt + Fixed payment obligations) / Shareholders’ Equity

Debt-to-Equity Ratio = ($500 + $1,000 + $500) / $1,000

Debt-to-Equity Ratio = 2.0

The calculated debt-to-equity ratio of the company is 2.0. The calculated D/E Ratio is more than 1.5 which is high for a low-risk investor like Susan.

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[title text=”advantage and disadvantage of debt to equity ratio” tag_name=”h2″]

advantage of debt to equity ratio

• Measures Profitability: Debt to Equity Ratio help to give an indication of how much profit will be available for the shareholders.
• Measures Risk: This ratio is one of the best way to measure the level of risk for investing at a company. Higher D/E will generally implies a higher risk. A lower D/E ration will generally indicate a lower risk. By understanding D/E ratio, the investor can decide if investing in the company fit within their risk tolerance level.

Tip: Use Debt-To-Equity Ratio to compare companies that have similar size and industry.

disadvantages of debt to equity ratio

• Sector/ Industry Dependent: Debt-To-Equity Ratio is very industry specific. Industries which require a larger investment in fixed assets will generally have a higher D/E ratio. Therefore the ratio can only be used to compare within the same industry.

why is debt to equity ratio important to investors

Debt to Equity Ratio is considered one of the most important financial metrics because it helps to measure the financial health and stability of a company.

Debt to Equity Ratio is the preferred way by most investors to determine how risky it is to invest in a company by looking at the leverage ratio of the company.

Debt to Equity Ratio is especially important in unpredictable times. D/E can help you in finding companies which can survive through unpredictable black swan events such as pandemic.

While you can also look into other financial metrics to find stocks that give a margin of safety, such as P/B Ratio to find undervalued stocks.

Other ratios, such as Quick Ratio, Current Ratio or Cash Ratio are usually used in concurrent with Debt to Equity Ratio to help investors to assess the risk level when investing in a company.

“I’ve seen more people fail because of liquor and leverage, leverage being borrowed money.

You really don’t need leverage in this world much.

If you’re smart, you’re going to make a lot of money without borrowing.”

– Warren Buffett