Introduction to Stock Payout Ratio for Investors - dummies

Introduction to Stock Payout Ratio for Investors

By Paul Mladjenovic

Investors can use the payout ratio to figure out what percentage of a company’s earnings is being paid out to stock owners in the form of dividends (earnings = sales – expenses). Keep in mind that companies pay dividends from their net earnings. Therefore, the company’s earnings should always be higher than the dividends the company pays out. Here’s how to figure a payout ratio:

Dividend (per share) ÷ Earnings (per share) = Payout ratio

The company CashFlow Now, Inc. (CFN), has annual earnings (or net income) of $1 million. Total dividends are to be paid out of $500,000, and the company has 1 million outstanding shares. Using those numbers, you know that CFN’s earnings per share (EPS) is $1 ($1 million in earnings ÷ 1 million shares) and that it pays an annual dividend of 50 cents per share ($500,000 ÷ 1 million shares).

The dividend payout ratio is 50 percent (the 50-cent dividend is 50 percent of the $1 EPS). This number is a healthy dividend payout ratio because even if CFN’s earnings fall by 10 percent or 20 percent, plenty of room still exists to pay dividends.

If you’re concerned about your dividend income’s safety, regularly watch the payout ratio. The maximum acceptable payout ratio should be 80 percent, and a good range is 50 to 70 percent. A payout ratio of 60 percent or lower is considered very safe (the lower the percentage, the safer the dividend).

When a company suffers significant financial difficulties, its ability to pay dividends is compromised. (Examples of stocks that have had their dividends cut in recent years due to financial difficulties are mortgage companies in the wake of the housing bubble bursting and the fallout from the subprime debt fiasco.) So if you need dividend income to help you pay your bills, you better be aware of the dividend payout ratio.