The Importance of the Dividend Payout Ratio

The dividend payout ratio (DPR) as an indicator of financial health is often overlooked. By looking at this ratio in both the current quarter and historically, you can get a sense of how the company is performing and whether it is effectively managing its capital and growth. When combined with other indicators, particularly dividend growth and earnings per share, you can make solid judgments about the company that will aid in the investment process.

Mechanics of the Dividend Payout Ratio

The dividend payout ratio is the percentage of a company’s net earnings that the company pays to investors as a dividend. The equation for determining the ratio is DPR = dividend / net earnings for the same period. Any earnings that you do not receive as a dividend are called retained earnings and are used by the company to fund ongoing operations. Companies tend to increase their dividend payout ratios as they mature and become more stable.

Tax Implications

Depending on what type of investor you are, you may prefer to invest in companies with a higher or lower dividend payout ratio. If you like immediate income, a higher ratio is preferable; growth investors prefer companies with lower ratios, including those that pay no dividend at all. Dividends are taxed as ordinary income, whereas long-term capital gains are taxed at a lower rate than ordinary income. Thus, there is a tax advantage to long-term growth in terms of stock price. High-growth companies tend to have lower ratios, preferring to invest their earnings in additional growth. As a company matures and its earnings plateau, it is more likely to declare a dividend or increase the payout ratio.

Once you own a stock, the dividend payout ratio will apply to you if you hold it across the ex-dividend date. This is an important consideration because, once taxes are included, your overall return on the stock is affected. Failure to be aware of this factor can lead to adverse and unwanted tax consequences.

Implications of the Dividend Payout Ratio

In most cases, if you observe that a company has a dividend payout ratio above zero, this implies that the company has some operating history and has reached profitability. It makes little sense for a company to pay dividends when it is not profitable or to plan to pay dividends before it has ever been profitable. If there is a dividend, the company has made money at some point.

If the dividend payout ratio is increasing, this implies that the company is maturing and planning on limited expansion. This can be a mixed signal, but it is one to which you should pay attention. This is different from an increasing dividend. The company’s revenues can increase, thus causing a higher dividend without a corresponding bump in the payout ratio. If the company is retaining fewer earnings, it believes it can do so without an adverse effect on capital requirements. When combined with net dividend levels and earnings growth, this metric can tell you quite a bit.

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