Updated July 21, 2023
Introduction to Dividend Payout Ratio
A dividend payout ratio (DPR)measures the amount of dividend which is distributed by the company to its shareholders based on the net income earned during the specific period. It is classified as the percentage of earnings which is given to the shareholders of the company in the form of dividends and provides a clear picture of how much the company is distributing its profit and to what extent it is ploughing it back for the future investments.
A dividend payout ratio gives us a clearer picture about how much the company gives back its shareholders a part of the total profit earned in the form of dividends and to what extent it is ploughing back the profit to use it for future investments, repay its debt or to add to its cash reserves. This ratio is a lot different to dividend yield because dividend yield compares the dividend generated by the company in comparison to the share price of the company. All the elements to be used to calculate this ratio can be easily found in the income statement of the company.
Formula to Calculate Asset Turnover Ratio
The formulas to calculate the dividend payout ratio are as follows:
Dividend paid is defined as the percentage of profit distributed by the company to its shareholders in the form of what we call it as dividend.Net Income is defined as the total earning for the company after deducting all tax and other liabilities associated with day to day conduct of the business.
The retention ratio is defined as the measure of the percentage of earning which is retained by the company from the profit earned. In simple words, it is just the opposite of the dividend payout ratio.
Dividend per share is the measure of dividend calculated on a per share basis whereas earning per share is the measure of earnings made on a per share basis.
Example of Dividend Payout Ratio
An example of Dividend Pay-out Ratio can be as follows:
Let us consider a business that has initially reported to have earned a net income of $50,000 at the end of the year. During the same period, the company had announced a dividend payout of $5,000 to all its shareholders. In this case to calculate the dividend payout ratio of the company we need to do the below calculation.
Solution:
Dividend Payout Ratio is calculated using the formula given below
Dividend Payout Ratio = Dividend Paid / Net Income
- Dividend Payout Ratio = $5,000 / $ 50,000
- Dividend Payout Ratio = 10%
A 10% dividend payout ratio means the company is paying 10% of its overall profit earned to its shareholders in the form of dividend and retaining back 90% to utilize it for its growth and future expansion or simply to enrich its cash reserves. This 90% of the profit which is retained back is also called retained earnings.
Interpretation of Dividend Payout Ratio
The dividend payout ratio is defined as the ratio between dividend paid by the company to the total net income earned by the company in a specific period or point of time. A higher number of this ratio is what shareholders prefer because this means the company is distributing the maximum amount of its profit in the form of dividends to its shareholders. Also, not always this is true because in certain cases a company may plough back its profit and offer a lesser dividend to its shareholders, which the company further uses for expansion or in other beneficial opportunities. A lower number of this ratio signifies that either the company is not performing well and generating enough profit for distribution or it may be a case where the company is retaining back a major portion of its profit for future use. Dividend payout ratios of companies operating in the same industry must be used for comparison as it differs from industry to industry.
Importance of Dividend Payout Ratio
The various importance of dividend pay-out ratio is:
- The dividend payout ratio indicates how much the shareholders are getting back in the form of percentage returns from the overall profit earned by the company.
- It is an important metric to determine how the business is functioning or operating and whether it has enough growth potential.
- A substantially high ratio of these metrics indicates the maturity of the management which shows the concern about providing value addition to its shareholders.
- An abnormally high ratio of this number can be alarming which at times proves that the net income of the company is going down but still the company prefers to let out dividends go to its shareholders.
Dividend Payout Ratio vs Dividend Yield
The basic difference between Dividend Pay-out Ratio and dividend yield is that the Dividend Pay-out Ratio is defined as the ratio between dividend paid to the total net income earned, on the other hand, dividend yield is defined as the ratio between the dollar value of total amount of dividend provided by the company on a per share basis to the dollar value price of per share. The dividend yield is defined as the rate of return earned by the shareholders on their investment whereas the DPR is defined as the portion of the net income or profit which the company distributes back to its shareholders and calls it a dividend.
Limitations of Dividend Payout Ratio
The limitations of the DPR are as follows:
- Not always a dividend pay-out ratio number may give us a true picture. At times we will see a very high number of this ratio but that always doesn’t mean a good trend. It may be a case, where the net income of the company is going down but still the company prefers to let out dividends go to its shareholders.
- Also, the lower number of this ratio might not always mean bad because the company may be ploughing back its profit for future expansion or growth where chances of profit generation are even more.
- A person needs to be a bit careful and have to do a bit analysis on the company before blindly believing in this ratio and investing solely based on it.
Conclusion
Dividend payout is a crucial metric for every business, be it big or small because it helps investors and shareholders to determine how effective or efficient the company and what is the scope of future potential growth associated with it. The only thing which one must understand for the comparison of this ratio is that ratios of companies operating in the same industry must be used for comparison as it differs from industry to industry.
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