Dividend Payout Ratio

The dividend payout ratio is calculated by dividing a company's dividend by its net income. The resulting number tells you what percentage of a company's net income is required to service or cover the dividend.

The long term dividend investor should pay close attention to both the payout ratio as well at the dividend growth rate, when evaluating a potential investment.

The Ideal Dividend Payout Ratio

Unfortunately, there really is no ideal payout ratio. It varies both by industry as well as individual company.

When evaluating a payout ratio, it's good idea to compare the current ratio to the company's historical ratio as well as ratios of other companies in the same or similar industries.

Sometimes, as part of its dividend policy, a company will also share the approximate payout ratio it targets.

A large and stable business that doesn't need to reinvest large amounts of its earnings back into the business in order to grow, can typically afford to maintain a much higher dividend payout ratio than a smaller, faster growing business that fuels its growth by plowing most of the profits back into the business.

Dividend Warning Signs

Paying attention to the payout ratio may provide useful insights into a company's future dividend policy and the dividend safety of your investment.

If, for instance, you see that a company's payout ratio steadily increases every year, that's a good indication that earnings are not keeping pace with the dividend growth rate.

And if the payout ratio exceeds 100%, the dividend is simply not sustainable. Of course, a one-time hit to net income could be the culprit, so use common sense. But, over time, a robust dividend growth rate must be matched by an overall stable payout ratio.

Finally, you should be aware that certain dividend paying companies are structured for tax purposes in certain ways that result in unusually high payout ratios. REITs, Master Limited Partnerships, and Energy Trusts, for example pay no corporate taxes as long as they distribute the bulk of their earnings (up to 90%) back to share and unit holders in the form of dividends.