What Is an Ideal Payout Ratio?

Payout ratios are not the first thing an investor usually sees when he is investing for dividends. Payout ratios have tremendous prediction power as they indicate what stage of business a company is in.

Below, we break down payout ratios into important brackets and definitions, which we believe might help investors identify income picks.

Where:
Annualized Dividend per share = Most recently observed dividend * previously observed frequency of dividend payments
Current calendar year EPS = Mean Analyst Basic EPS estimates for the current calendar year

A payout ratio less than 0% is only possible if the analyst’s estimates for EPS for the next year end are negative. A dividend to common shareholders is paid out of the bottom line. If the bottom line itself is expected to be negative next year, then the dividend is not likely to continue going forward.
Some companies continue to pay dividends due to 2 reasons:

1. They don’t want to look bad when they cut their dividend, which can have an adverse impact on their share price and
2. It’s a matter of pride for a lot of companies to continue paying dividends. Some companies have a long history of paying dividends—as far back as 50 years and in some cases even 100 years. Cutting or eliminating a dividend that was being paid for such a lengthy period of time can have a devastating impact on shareholder confidence.

Here we have analyzed negative payout ratios in-depth.

A range of 0% to 35% is considered a good payout. A payout in that range is usually observed when a company just initiates a dividend. Typical characteristics of companies in this range are “value” stocks. If the company recently started paying a dividend, the market doesn’t value it as much as a company that has been paying a dividend for years. You will typically find low P/E stocks in this range. This range is usually synonymous with “value investing” and not “income Investing”.

The list can also feature future Dividend Aristocrats who now have enough cash flow to start paying a dividend, as well as grow. The list will also feature sectors that aren’t very dividend friendly. A perfect example could be technology stocks. Technology has an inherent need to continue to research and develop, or they will be left behind. For R&D, they need cash and, hence, typically retain all or most of their earnings.

A range of 35% to 55% is considered healthy and appropriate from a dividend investor’s point of view. A company that is likely to distribute roughly half of its earnings as dividends means that the company is well established and a leader in its industry. It’s also reinvesting half of its earnings for growth, which is welcome.

A company typically raises money from 2 sources: debt and equity. Debt is issued in the form of bonds, a line of credit or a secured/unsecured loan. Companies pay an interest on their debt before the PAT (profit after tax) is declared, while dividends are a form of rewarding equity holders; however, that is paid after PAT is declared. Thus, both major providers of capital are paid off by the company before retaining the remaining profit.

Payout ratios that are between 55% to 75% are considered high because the company is expected to distribute more than half of its earnings as dividends, which implies less retained earnings. A higher payout ratio viewed in isolation from the dividend investor’s perspective is very good. But, it also implies low retained earnings for growth, which dividend.com treats as ‘bad’ because it leaves less room for the company to employ CAPEX plans. This, in turn, limits the company’s ability to grow dividends in the future.

A payout ratio that is between 75% to 95% is considered very high. It implies that the company is bordering towards declaring almost all the money it makes as dividends. This increases the risk of the company cutting its dividends because our formula is forward looking. To maintain a healthy retention ratio, the company would either not grow its dividend or cut it down.

Companies that have forward-looking payouts of 95% to 150% are distributing more money than they earn. A poor earnings estimate is likely to result in an unsustainable payout ratio in the triple digits. Only two things can happen from here: the dividend would be cut or eliminated altogether.

If the payout ratio exceeds 150%, it’s as bad as a company that has negative payout ratios.

To emphasize the difference between the two, negative payout ratios result when the earnings estimates are negative and the company is still paying a dividend today as explained above, while payout ratios in the triple digits occur when the company has positive earnings, but they are still less than the distribution the company is making.

Investors should always prefer healthy payout ratios over high payout ratios. Very high dividend distributions may be attractive in the short term, but they may not last going forward as discussed above. New Dividend Initiators can also be preferred if someone is looking for a hybrid value/income pick.

To learn the basics about the dividend payout ratio, read our article The Truth About the Dividend Payout Ratio. For a more thorough understanding, you can read What is a Target Payout Ratio and What Are Negative Payout Ratios?.