What it means
Every dollar a company earns has two possible destinations: it can be paid to shareholders or kept in the business. The payout ratio measures the split.
A company that pays out little is retaining most of its profit, presumably to fund investment that will earn more than shareholders could elsewhere; a company that pays out most of its profit is signalling that it has few such investments, or that its shareholders prefer income, or both. Neither is right in general.
The appropriate ratio depends on the company's opportunities, its stage of life, its industry, its balance sheet and its shareholders' expectations, and a board's choice of payout ratio is the operational expression of its dividend policy. The pattern across industries follows the logic of opportunity.
Young, fast-growing companies with high returns on reinvested capital pay little or nothing; every dollar retained earns more than a dollar distributed. Mature companies with steady profits and limited growth pay out a large share, often 50% to 70%.
Regulated utilities and infrastructure companies, whose investment is funded largely by debt and whose returns are set by regulators, commonly pay 70% to 90%. Real estate investment trusts and similar vehicles are required by their tax status to pay out most of their income, and their ratios approach or exceed 100% of accounting earnings, though they are measured on cash-based figures.
A company whose payout ratio is out of line with its peers is worth a question: a mature company retaining most of its profit may be hoarding cash or investing badly; a growth company paying a large dividend may be short of ideas. The retained share links the payout ratio to growth.
The retention ratio is one minus the payout ratio, and the sustainable growth rate, the rate at which a company can grow its earnings and its equity without raising new capital or increasing its leverage, is the retention ratio multiplied by the return on equity. A company earning 15% on equity and retaining 60% of its profit can grow at 9% a year from its own resources; if it raises its payout to 80%, its sustainable growth falls to 3%.
A board that wants both a high payout and fast growth must fund the difference with debt or new shares, and the payout ratio is where that tension is visible. The ratio should be read with care about its inputs.
Net income can include one-off gains and losses that distort a single year's ratio, so companies and analysts often use underlying or adjusted earnings, and a ratio calculated on a bad year can exceed 100% without meaning the dividend is unsustainable if the earnings dip is temporary. Conversely, a ratio calculated on accounting earnings can look comfortable when the company's cash generation does not support it, because profit is tied up in working capital or capital expenditure exceeds depreciation; a cash payout ratio, dividends divided by free cash flow, tests that.
And a payout ratio above 100% for more than a year or two means the company is distributing its reserves, which can be a deliberate return of surplus capital or a sign of a dividend the board cannot bring itself to cut. For a board, the payout ratio is a policy tool.
Some boards target a ratio, paying out a fixed percentage of each year's earnings, which keeps cover constant but makes the dividend volatile. Others target a progressive dividend, raising the amount steadily, which makes the ratio move inversely with earnings and requires the ratio to be low enough in good years to absorb bad ones.
Others combine a base dividend at a low ratio with a variable element tied to cash flow. Whichever is chosen, the ratio in a normal year and its projected level in a downside case are what determine whether the policy can be kept, and a board that sets the ratio too high in the good years is the board that cuts the dividend in the bad ones.
In practice
Real-world examples.
Example
A software company pays no dividend and has a payout ratio of zero, retaining all its earnings to fund development that earns a 30% return on equity.
Example
An electricity utility pays out 80% of its earnings, funds its investment programme with debt, and grows its dividend at about the rate its regulator allows its asset base to grow.
Example
A retailer's payout ratio rises from 45% to 110% over three years of falling profits while its dividend is held flat, and its board finally cuts the dividend to bring the ratio back to 50%.
Think of it
“Payout ratio shows what portion of profits goes to shareholders versus being reinvested in the business.
Formula
Calculation
Dividend payout ratio = Total dividends / Net income attributable to ordinary shareholders
Equivalent: Dividend per share / Earnings per share
Retention ratio = 1 minus Payout ratio
Sustainable growth rate = Return on equity x Retention ratio
Cash payout ratio = Total dividends / Free cash flow
Dividend cover = 1 / Payout ratio
Worked example. A company earns net income of $12,000,000, has 10,000,000 shares (earnings per share $1.20), pays a dividend of $0.48 a share, has a return on equity of 15%, and generated free cash flow of $8,000,000.
- Total dividends = $4,800,000
- Payout ratio = $4,800,000 / $12,000,000 = 40% (or $0.48 / $1.20)
- Retention ratio = 60%; retained earnings for the year = $7,200,000
- Sustainable growth rate = 15% x 60% = 9% a year
- Cash payout ratio = $4,800,000 / $8,000,000 = 60%; dividend cover = 2.5 times
Policy comparison. If the board raised the payout ratio to 80% ($0.96 a share, $9,600,000):
- Retained earnings would fall to $2,400,000; sustainable growth to 15% x 20% = 3%
- The cash payout ratio would be 120%: the dividend would exceed free cash flow by $1,600,000, which would have to be borrowed
- The company would be choosing income today over growth tomorrow, and funding part of the income with debt
Bad year. If net income fell to $4,000,000 and the $0.48 dividend were maintained, the payout ratio would be 120% for that year. If the fall were temporary, the board might hold the dividend and accept the ratio; if it were the new normal, the dividend would have to be cut to restore a sustainable ratio.Case study
Seen in the real world.
A family-controlled manufacturing company had for a decade paid out about 90% of its earnings, because the family shareholders relied on the dividend for income and the board saw no reason to accumulate cash. On net income of $10,000,000, dividends of $9,000,000 left $1,000,000 a year in the business. The company's plant was ageing, its capital expenditure had been held at about its depreciation charge of $5,000,000, and its market share was slipping to competitors with newer equipment.
A strategic review identified $8,000,000 a year of investment needed for three years to modernise the plant, against internal funding of $6,000,000 a year (depreciation plus the $1,000,000 retained). The shortfall of $2,000,000 a year could be borrowed, but the company's return on equity of 12% and its 10% retention ratio gave a sustainable growth rate of 1.2%, and borrowing to fund investment while paying out 90% of earnings would raise leverage every year without end.
The finance director set out the arithmetic: at a 60% payout, retained earnings would be $4,000,000 a year, internal funding $9,000,000, the modernisation fully funded, and the sustainable growth rate 4.8%. The dividend would fall from $9,000,000 to $6,000,000.
The family shareholders resisted, then negotiated. The board adopted a 60% payout ratio for the three investment years, with a commitment to review it at 70% thereafter and to consider special dividends once the plant was modernised. The dividend fell by a third, and two family members sold part of their holdings to fund their income.
Four years later, the modernised plant had raised the company's return on equity to 16%, net income to $14,000,000, and the 70% payout gave a dividend of $9,800,000, higher than the $9,000,000 the family had been receiving before the cut. The chairman's letter observed that the company had been paying its shareholders 90% of its earnings and slowly giving its business away to competitors, and that the payout ratio had been the number that showed it.
Watch out
Common mistakes.
- Reading a single year's payout ratio without checking whether the earnings were distorted by one-off items or by a temporary dip, which can make a sustainable dividend look unsustainable or the reverse.
- Judging a payout ratio by accounting earnings alone in a business where capital expenditure exceeds depreciation, so that the cash payout ratio is far higher than the earnings ratio suggests.
- Setting a high payout ratio and a growth ambition at the same time without funding the gap, which raises leverage year after year.
Questions
People also ask.
What is the difference between the payout ratio and dividend cover?
They are reciprocals: a payout ratio of 40% is cover of 2.5 times. The payout ratio describes the share of earnings distributed; cover describes the margin by which earnings exceed the dividend.
What is a good payout ratio?
It depends on the company's opportunities and industry. Growth companies pay little; mature industrials 30% to 60%; utilities 70% to 90%; property trusts near 100% of cash earnings. The useful questions are whether the ratio leaves enough retained profit to fund the company's plans and enough cover to survive a bad year.
How does the payout ratio affect growth?
Through retention. The sustainable growth rate is the return on equity multiplied by the retention ratio, so a higher payout means slower growth from internal funds unless the company borrows or issues shares. A company cannot both pay out most of its earnings and grow fast without external capital.
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