What is a Payout Ratio?
How Does a Payout Ratio Work?
At the end of a specified period, companies will sometimes pay out dividends for every share owned. Theoretically, the money for these dividends comes from the company's earnings from that period. Thus, the payout ratio is calculated as the percentage of earnings paid out as dividends.
The formula for calculating the payout ratio is:
Payout ratio = (dividends paid/net earnings for the period) x 100
For example, if Company XYZ earned $1.00 per share in the fourth quarter and paid a dividend of $0.60 per share, its payout ratio would equal 60%.
Why Does a Payout Ratio Matter?
A company's payout ratio can reveal many things. A low ratio may indicate the company is using much of its earnings to reinvest in the company in order to grow further. Conversely, a high payout ratio can indicate a willingness to share more of the company's earnings with investors. Large, slow-growth companies such as telecoms or utilities offer typically offer high payout ratios.
Investors should be wary of payout ratios over 100%, as this means the company is paying out more than it is earning -- an unsustainable condition. There are some instances, however, where payout ratios over 100% simply indicate a company has high depreciation costs -- which are a non-cash charge that impact net earnings, but not cash available to pay investors.