Want to know the answer to "What is a good dividend payout ratio?" 

By the time you've finished this article, you will understand what a payout ratio is, how to calculate it, what makes it good or bad and why it all matters. 

The bottom line is dividends. The payout ratio is a measure of dividend health and can give investors an idea of what to expect from future dividend payments. Dividend health is essential when looking at dividend growth stocks because those with the best payout ratios have the best outlook for sustained growth. 

What is a Dividend Payout Ratio?

What is the dividend payout ratio? Simply put, a dividend payout ratio is the amount of a company's profits that it pays its investors. It is calculated based on the latest earnings reports and outlook for future earnings and dividend payments and used as a measure of dividend health. On its own, the dividend payout ratio is not enough to include or disclude a stock from a portfolio, but it is a guide as to the best dividend stocks by sector, industry and peer group. 

How to Calculate Dividend Payout Ratio

The dividend payout ratio, a simple formula, is as vital as the dividend yield formula for dividend stocks. To calculate the dividend payout ratio, divide the dividend payout by the company's earnings. You can do this on a quarterly or annualized basis and with rear or forward-looking data. How and when are dividends paid out? Usually, dividend payouts are telegraphed via the earnings reports and dividend declarations on a regular schedule. 

The dividend payout ratio formula looks like this: 

Dividend Payout Ratio = Annual Dividend Payments/Annual Earnings 

For a company paying $1 in dividends and earning $4 in annual EPS, the formula looks like this: 

$1/$4 = 0.25 or 25%

For investors, the payout ratio can also answer the question, "How are dividends calculated?" If you know the company's payout ratio, you can always multiply that by the latest earnings figures to gauge upcoming payments. However, the dividend payout ratio can't determine the number of dividend stocks you should own. 

How to Analyze a Dividend Payout Ratio

What is a good dividend payout ratio for a company? You can use the dividend payout fundamental analysis. As a rule of thumb, you should avoid higher payout ratios and add lower ones whenever possible. What makes a "high" payout ratio and a "low" payout ratio will differ from sector to sector and industry to industry, but anything below 50% is relatively "good." At 50%, you get into risky territory, while anything above 80% is dangerous. After all, what is dividend yield if the company can't pay it? 

The real question is how does the payout ratio stack up versus the industry, sector and broad market? Understanding what makes a payout ratio high or low relative to peers is key to picking the top dividend stocks and how to invest in them. A low payout ratio relative to the broad market may be high for the sector or industry, making the stock in question a potentially poor choice. 

Ultimately, you need to know if quarterly earnings and quarterly earnings alone can sustain the dividend payments or if the company will have to pay distributions from retained earnings or fund them with debt. In the first instance, paying from retained earnings may signal a red flag but is moot if net annual earnings are more than net annual distribution payments. 

In the second case, funding dividends with debt, the company may be on a downward spiral that can only end with a dividend cut or suspension. Funding dividends with debt, even partly, means taking on more debt with each passing quarter and increasing the number of debt payments. In this case, in the absence of widening margins or increasing earnings, an increasing debt load will cut deeper and deeper into the company's ability to pay its dividend until it cannot pay it anymore.

To analyze the dividend payout ratio, multiply the payout ratio by the company's earnings and then subtract that number from the earnings. If the remainder is sufficient to pay debt requirements and fund the business, it is a "good" payout ratio.

For example, if Company A earns $1 billion in annualized profit and has a dividend payout ratio of 37%, it pays $0.37 billion, or $370 million in dividends. If the remaining $630 million in earnings is more than the company's cost of carrying debt, it is a "good" payout ratio. 

Coverage Ratio

The coverage ratio, or debt service coverage ratio, is the amount of company earnings used to service the debt. It is expressed as a decimal number or percentage point and is a complimentary figure to the payout ratio when analyzing dividend health. If the company pays 60% of its earnings as dividends and 60% to cover its debt, something is wrong. In this instance, the company is paying out more than it is earning, a bright red flag for investors. 

If Company XYZ pays 45% of its earnings in dividends and only 20% to cover debt, the dividend appears to be healthy. In this case, the company pays 65% of its earnings to shareholders and creditors while retaining the other 35%. Assuming there are no other draws on earnings, share repurchases or debt repayments, etc., the company's cash balance should increase. 

Examples of a Good Dividend Payout Ratio

Dividend payout ratios are relative to the business size, maturity, sector and industry. Here are two examples to better answer the question of a good payout ratio for a dividend stock:

First, we look at the utility sector, which is known to have high payout ratios. This is because they are not growth-oriented companies, do not retain a large portion of earnings to fund growth and are in business to a large degree solely to provide income to their investors. Second, we look at the technology sector, which is a growth-oriented sector and is well-known for retaining capital for purposes such as R&D, advertising and acquisitions.  

Example 1

Investors looking to buy into the utility sector for its dividends may be shocked to see payout ratios above 70%. This is well above the broad market average and levels deemed "safe" for other industries but are typical for this sector. In this example, we have Duke Energy Corporation, the Southern Company and American Electric Power Company which have payout ratios between 62% to 77%. 

The highest payout ratio belongs to Duke Energy, the largest and most established of the three companies. It also has the highest yield at 3.9%, which may make it the most attractive from an income perspective. However, the best stock for long-term holding AEP may be the best choice. It has the lowest yield today, the lowest payout ratio and the lowest valuation. In this light, investors who intend to buy and hold a utility stock may find AEP more attractive because it has a more robust outlook for dividend growth and comes at a discount.  

Example 2

In this example, we're looking at three high-quality blue-chip tech stocks. Looking at them strictly from the payout ratio perspective, Apple is the most attractive at only 15%. It means keeping 85% of its earnings for corporate use or to build the cash balance, which means the current payment is safe and could grow substantially over time. 

The caveat with Apple is twofold. The first is the value; the second is the yield. Trading at 21x its earnings, it is highly valued compared to the broad market S&P 500 and its peers in the technology sector. While Juniper Networks and Cisco both have much higher 44% payout ratios, these are not "too high". At 44%, these companies still retain sufficient earnings to fuel growth and maintain healthy balance sheets while raising their dividends. 

Both also pay much higher dividends and come at a better value, but the question of what is a good yield is just as relative as the payout ratio. By viewing these companies on a value, yield and payout ratio basis, Cisco is the best choice. 

The Dividend Payout Ratio is a Guide to Dividend Health

The dividend payout ratio is an important metric to understand and track because it is the first indication of dividend health. A high payout ratio may not mean trouble but, as a rule of thumb, a lower payout ratio is much better. The takeaway is that payout ratios are relative to business size, maturity, sector and industry so are not always comparable. What investors need to learn from the figure is if the dividend payout in question is sustainable or if there is a danger that it will be cut or suspended. 

FAQs

Take a look at a few frequently asked questions answering "What is a good payout ratio for a dividend stock?" and other FAQs.

What is a good payout ratio for dividends? 

"What is a good payout ratio for dividends?" is a good FAQ after "What is payout ratio?" The best answer: One that the company can sustain. If the company can afford to pay it and service its debt while funding operations and any growth ambitions, the payout ratio is as good as it needs to be. 

What is a good payout ratio for a company? 

Same answer. 

Do investors prefer high or low dividend payouts?

Investors prefer high payouts or dividend yield and low payout ratios. The lower the payout ratio the better because it means there is more room for dividend increases. 

What does a 100% dividend payout ratio mean?

A 100% dividend payout ratio means the stock is paying all or 100% of its earnings in the form of dividends. This is not a good thing because it is an unsustainable amount that leaves the company with little to no capital should the need arise.