Financial ratios can help you evaluate how attractive or beneficial a company’s stock may be before you decide to invest in it. The Dividend Payout Ratio (DPR) is one such financial metric that you need to look into, especially if you are looking for periodic income along with potential capital appreciation.
Check out what the dividend payout ratio is, how to calculate and interpret it and why it matters for long-term investors.
What is the dividend payout ratio
The dividend payout ratio is a measure of the percentage of a company’s profits that are paid out as dividends relative to its net income. When companies earn profits consistently, the general practice is to circulate the profits back into the business to fuel further growth. However, some companies occasionally distribute a portion of their profits to their shareholders through the medium of dividends.
The dividend payout ratio helps you compare a company’s dividends with its net income so you know how much of its revenue is distributed back to its investors. The dividend amount per share varies from one year to the next, as does a company’s net income. So, as these metrics change, the dividend payout ratio will also continue to fluctuate.
Also read: What is free cash flow?
Dividend payout ratio formula and calculation
The formula for the dividend payout ratio is contained in its definition itself. Check out the DPR formula below.
Dividend payout ratio = (Total dividends paid ÷ Net income) x 100
Alternatively, you can also calculate the DPS on a per-share basis using the dividend per share and the Earnings per Share (EPS). This formula is shown below:
Dividend payout ratio = (Dividend per share ÷ Earnings per share) x 100
Let us discuss an example to better understand how the dividend payout ratio can be computed using either of the formulas mentioned above. Consider the following financial particulars for a company during FY23.
- Dividends paid: Rs. 5,00,000
- Net income: Rs. 75,00,000
- Outstanding shares: 1,00,000
This means that the dividend per share is Rs. 5 (i.e. Rs. 5,00,000 ÷ 1,00,000 shares) and the EPS is Rs. 75 (i.e. Rs. 75,00,000 ÷ 1,00,000 shares). The DPR can be computed using both dividend payout ratio formulas.
Dividend payout ratio:
= (Total dividends paid ÷ Net income) x 100
= (Rs. 5,00,000 ÷ Rs. 75,00,000) x 100
= 6.67%
Alternatively, it can also be
= (Dividend per share ÷ Earnings per share) x 100
= (Rs. 5 ÷ Rs. 75) x 100
= 6.67%
Also read: What are cash flow and fund flow?
Understanding the dividend payout ratio
The dividend payout ratio tells you the percentage of its net income that a company distributes as dividends. Naturally, the higher the ratio, the better it is for prospective investors because it means they will receive a decent level of income periodically. However, that may not always be the case. Let us decode high and low DPRs separately.
- High dividend payout ratio: A high DPR is generally a favourable indicator for investors. However, if the dividend payout ratio is abnormally high, it may mean that the company is distributing too much of its profits and not reinventing enough back into the business. For some long-term investors who prioritise capital appreciation, this may not be an attractive proposition.
- Low dividend payout ratio: By contrast, a low DPR or no DPR may not be preferred by investors who want to earn income periodically via dividends. That said, if a company is profitable but still has a low dividend payout ratio, it may mean that all of the profits are reinvested to fund the company’s future growth. For long-term investors who are eager to capitalise on such growth, this may be a green flag.
Why the dividend payout ratio is important
The dividend payout ratio is an important financial metric because of the following reasons:
- Income stability assessment: The DPR helps you assess how stable a company’s income and profits are. If the dividend payout ratio is consistent or growing, coupled with increasing profitability, it may be a sign of favourable growth.
- Financial health evaluation: You can also use the dividend payout ratio to evaluate the financial health of a company. If a high DPR is sustained across several periods, it may indicate that the company can distribute its earnings without compromising its profitability.
- Market perception: The dividend payout ratio also affects market perception. A growing DPR may affect valuation favourably, while a decreasing DPR may temporarily affect the valuation adversely because investors may view it as a sign of financial trouble.
- Investment strategy and planning: You can use the dividend payout ratio in combination with other relevant indicators to create an informed investment strategy over the long term. If you prioritise income, a high DPR may be ideal. If you prioritise growth, a low DPR may be suitable.
Also read: What is fundamental analysis?
Conclusion
The dividend payout ratio is a useful metric to gauge the financial strength of a company as well as its potential as an income-generating investment. To get more in-depth insights into how lucrative or not a company’s stock may be, consider the dividend payout ratio along with other parameters like the dividend yield, Earnings per Share (EPS) and Price-to-Earnings (P/E) ratio, among other indicators.
Reference URL
https://cleartax.in/glossary/dividend-payout-ratio
