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What is the payout ratio and how is it interpreted?

The payout ratio is simply the dividend by share (DPS) as a percentage of the earnings per share (EPS): Payout Ratio = 100 x DPS / EPS. So, if the dividend is 50c and the earnings per share is 75c, the payout ratio is 100 x 50 / 75 = 66.67%

Interpreting the payout ratio is not quite so straight-forward. It all depends on the situation.

Firstly, though it is important to understand that by law a company can only pay dividends out of profits. To protect creditors, companies may not pay out their capital as a dividend. So, to pay a dividend, a company must have current year profits or profits retained from previous years available to cover the dividend.

If the payout ratio is more than 100%, it means that the company is paying out all of its current year profits and also some retained profits. This is not sustainable. It is often a sign of problems. In these situations, it is necessary to inquire into the circumstances and be convinced that it is a temporary measure.

The payout ratio should desirably be less than 100%. This gives some margin of safety in that the profits may fluctuate somewhat without endangering the dividend. Many companies recognise that some shareholders live off dividends and they try to give some certainty to the income flow. They will be reluctant to cut dividends. They herefore tend to pay out less than 100% in most years, so that in bad years they can hold the dividend. If the payout ratio is normally lower and then moves toward or to 100%, it is necessary to enquire further into the circumstances, to ensure that this is temporary.

Other companies have a policy of paying out a consistent proportion of earnings. They may therefore have a policy which, for example pays out 80% of earnings. In this case, the payout ratio is not as important as the earnings, because dividends will rise and fall with earnings.

Payout ratios are affected by the degree to which companies have a need to retain earnings for growth through increased business levels or through acquisitions. If a company has few growth possibilities and is throwing off lots of cash that the directors have no scope to employ in the business, the payout ratio may be high. However, if the business is growing very rapidly and there are abundant opportunities for further growth, the payout ratio may be very low.

So, in the final event, it all depends on the situation. However, if you encounter a fairly normal situation where the payout ratio is 60 to 80%, there is probably not great cause for concern.