Business, Legal & Accounting Glossary
The payout ratio, sometimes called the dividend payout ratio, is the percentage of a company’s earnings that it pays out as dividends.
If a company has yearly earnings of $10 and pays $2 in dividends, its payout ratio is 2/10, or 20%. Generally, mature companies with few growth opportunities have a high payout ratio, because returning earnings to shareholders represents the best use of profits. A rapidly expanding firm, however, often has a low payout ratio, because it uses the cash instead to invest in businesses with high growth potential. A firm’s payout ratio reflects its need to offer investors a satisfactory return on their investment, which comprises both capital appreciation and cash dividends. Investors in expanding firms often enjoy substantial capital appreciation and thus are satisfied even when the payout ratio is zero. Mature firms have fewer expectations of high growth to drive their stock price, thus they satisfy investors with large dividends and a high payout ratio.
The size of the payout ratio is often dependent on the growth stage the company is in. For a young, rapidly growing company, the payout ratio is going to be small (or zero) as the company keeps most or all of its earnings to reinvest in growing the business. As the company matures and begins to pay a dividend, the payout ratio increases.
The ratio is also dependent on the industry in which the company operates. Utilities, for instance, don’t grow very fast and have relatively large payout ratios. Computer hardware companies, on the other hand, always need money for research & development and are reinvesting in themselves, so the payout ratio is quite small.
In other words, a company must balance between sharing profits with shareholders through dividends and retaining profits to reinvest in the business to grow the company. Obviously, the more it retains and reinvests, the more rapidly the company can grow.
Analysts can calculate the implied growth rate that the company can maintain using the payout ratio and the return on equity.
<math>Implied\ growth\ rate = (1 – payout\ ratio) * (return\ on\ equity) = (retention\ ratio) * (return\ on\ equity)</math>
For instance, if the payout ratio is 60% and the return on equity is 20%, the implied growth rate is 8%.
The payout ratio is the amount of net income that is paid out as dividends to common shareholders, expressed as a percentage.
Payout\ ratio = \frac{dividends\ paid}{net\ income}
Dividend
Return on equity
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This glossary post was last updated: 6th August, 2021 | 0 Views.