Dividend payout ratio measures the percentage of net income that is distributed to the shareholders in a from of dividend. In other words, it a measurement of the amount dividends paid to shareholders in relationship to the total amount of net income of the company. The amount that is not paid to shareholders and it is kept by the company to pay off debt, add to cash reserves and grow the business is called retained earnings.
The dividend payout ratio can be calculated by the following formula:
Dividend Payout Ratio = Dividends Paid / Net Income
The retention ratio can be also calculated on a per share basis and since the dividend payout ratio a revers of the earnings rotation ratio, if you have know the retain ratio you can calculate the dividend payout ratio like this:
Dividend Payout Ratio = 1 − Retention Ratio
A company reports a net income of $200,000 for the year. In the same time, it has paid $40,000 in dividends to its shareholders. The Dividend payout calculation will be as follows:
Dividend Payout Ratio = Dividends Paid / Net Income = $40,000/$200,000 = 20%
The company is paying 20% of its net income as dividend to its shareholders. The remaining 80% of the income are kept as retained earnings.
The dividend payout ratio can be used by investors to determinate the type of company they are investing in. Investors who a looking for investing in businesses for income and are not interested in generating capital gains from the growth of the business would prefer company with higher dividend payout ratio. Conversely an investor that is looking for capital growth on his investment and prefers lower regular income payments will look for a company with lower if not zero dividend payment ratio. The more a company is growing the more an investor would prefer if the business is retaining all of its earnings and reinvest them into growth. As businesses mature and get more stable and start grow at a more slow pace, the more they tend to return earnings back to investors. It is important to take into account the influence on stocks buyback to dividend payout ratio. Some company prefer to use stock buyback as a mechanism to return funds to investors. In this type of situations we need to take into account the influence of stock buyback to the dividend payout ratio as it might distort the actual returns to investors.