The payout ratio indicates the percentage of a corporation’s earnings which are distributed as cash dividends to its stockholders.
Typically, the payout ratio is computed by using the per share common stock amounts. For example, if a corporation’s cash dividend per share of common stock for the previous year was $0.72 and the common stock’s earnings per share for that year were $1.20, the payout ratio was 60% ($0.72/$1.20).
Since dividends are formally declared by a corporation’s board of directors, the corporation should have a policy regarding its payout ratio. The payout ratio policy should reflect the needs of the corporation as well as the interests of the stockholders. For instance, a startup corporation will likely have a payout ratio of 0%, since 1) the corporation will need to retain (reinvest) any profits in order to compete and grow, and 2) its stockholders want their investments to grow in value instead of receiving taxable dividends.
A large, established public utility with stable earnings and the ability to issue bonds payable (with low, tax-deductible interest payments) may strive for a payout ratio of 70%. This high payout ratio is wise for the utility, its customers, and its stockholders. This is likely to attract investors wanting a steady stream of cash dividends which increase with inflation.
To gain deeper insights for a specific corporation’s payout ratio, we recommend reviewing the following components of its statement of cash flows:
- cash from operating activities
- cash dividends paid (part of the cash flows from financing activities)
For a U.S. corporation with stock that is publicly traded, it is wise to review the pertinent parts of its Form 10-K.
