Dividend payout ratio and dividend sustainability

The dividend payout ratio tells you what portion of a company's profit is paid to shareholders as dividends. It is the main tool for judging whether a dividend looks comfortable or stretched, because a company that pays out more than it can afford will eventually have to borrow, cut investment or reduce the dividend.

The formulas

Payout ratio (earnings) = Dividends per share / Earnings per share
                        = Total dividends / Net income

Payout ratio (free cash flow) = Total dividends / Free cash flow

Retention ratio = 1 - Payout ratio

The retention ratio is the share of profit the company keeps to reinvest in the business, repay debt or build cash.

The first version uses accounting profit and is the one most often quoted. Earnings per share can be basic or diluted, and the difference is covered in basic vs diluted EPS. The second version uses free cash flow, which is the cash left after operating costs and capital spending. Many analysts prefer it because dividends are paid in cash, not in accounting profit. Net income and cash flow can differ a great deal, as explained in operating cash flow vs net income.

Some analysts also include share repurchases to calculate a "total payout" ratio, since buybacks return cash to shareholders too.

Example (illustrative numbers)

A company reports earnings per share of $4.00, pays dividends of $1.60 per share, and has 250 million shares outstanding. Its free cash flow for the year is $500 million.

Earnings payout ratio = 1.60 / 4.00 = 40%
Total dividends       = 1.60 x 250 million = $400 million
FCF payout ratio      = 400 / 500 = 80%
Retention ratio       = 1 - 0.40 = 60%

On earnings, the dividend looks well covered, with 60% of profit retained. On free cash flow, however, 80% of the cash is paid out, leaving a much smaller cushion. The gap between the two usually comes from large capital spending, working capital needs, or accounting items such as depreciation and non-cash charges. Neither number alone is the whole story, which is why both are worth checking.

How to read it

Rules of thumb, which change with the type of business:

Industry differences are large. Real estate investment trusts (REITs) are generally required to distribute most of their taxable income to keep their special tax status, so high payout ratios on net income are normal for them; and because depreciation on property is a big non-cash charge, cash-based measures suit them better. Regulated utilities with predictable earnings also tend to pay out a large share of profit. Fast-growing technology companies often pay little or nothing because they can earn more by reinvesting. See the real estate and utilities sectors.

What matters beyond the level:

• Coverage by free cash flow over several years, not one.
• Stability of earnings. A 70% payout on very stable earnings may be safer than a 40% payout on earnings that swing wildly.
• Balance sheet strength. A company with low debt can sustain a higher payout than one that must also service heavy borrowing; see the net debt to EBITDA ratio.
• Dividend history. A long record of maintained and growing dividends suggests management treats the payout as a commitment, though it does not guarantee the future. For this approach see dividend growth investing.

Common mistakes and limits

Judging by the yield alone. A high dividend yield can be a sign of a falling stock price and a dividend the market expects to be cut, not of generosity. Checking the payout ratio helps separate sustainable yield from a stressed one.

Taking one-year earnings at face value. A depressed or one-time-inflated earnings figure makes the ratio jump around. A cyclical company may show a payout ratio over 100% at the bottom of the cycle and 20% at the top. Average over several years.

Ignoring negative or tiny earnings. If earnings are negative, the ratio is meaningless. A payout ratio of several hundred percent on tiny earnings tells you little other than that the dividend is not covered that year.

Forgetting about debt-funded dividends. A company can pay dividends beyond its cash generation by borrowing or selling assets for a time. Look at whether debt is rising while the payout is high.

Confusing a low ratio with a safe dividend. A low payout ratio on weak, collapsing earnings is no guarantee. Coverage today does not ensure coverage tomorrow.

Assuming the ratio predicts cuts. Payout above 100% raises the odds of a reduction, but it does not make one inevitable, and companies with comfortable ratios still sometimes cut. The ratio is a risk indicator, not a forecast.

Where to see it on StocksXray

Dividends form the final 10% of the X-Ray Score, and companies that pay none skip that lens, with the weights re-scaling across the others. Stock pages carry a red flag for dividends above free cash flow, which is the cash-based version of this test, along with a history of dividends and splits. The dividend calendar shows dividend dates, and the methodology page explains the scoring.

Key takeaways

• The payout ratio is dividends divided by earnings (or by free cash flow); the retention ratio is what is left.
• Check both versions, because profit and cash flow often differ.
• Acceptable levels vary by industry; REITs and utilities pay out more than growth companies.
• Look at multi-year coverage, earnings stability and debt, not a single year.
• A payout above 100% or a dividend above free cash flow warrants a closer look, but neither predicts a cut on its own.