Understand and Calculate the Dividend Payout Ratio
The Dividend Payout Ratio indicates the portion of earnings used to pay dividends to shareholders. The payout ratio, which often varies by industry, can help investors understand what a company is doing with its earnings and is often affected by current market conditions and tax laws.
Companies with high growth aspirations tend have low (or no) payout ratios. As companies mature, they often choose to return some of the earnings back to investors. The choice investors make regarding the dividend payout ratio is largely dependent upon personal investment style and goals.
Dividends and Investment Style
Many investors look for the company to reinvest earnings to fuel growth in the hopes of realizing capital gains through stock price appreciation. Other investors have an income-based approach and look for companies that offer cash dividend payments. Along these lines, it’s worth noting that, historically, dividends have provided more than 40% of a stock investor’s total investment return.
The Dividend Payout Ratio and Financial Stability
Like other financial ratios, dividend payout can offer a glimpse into the financial health of the company. For example, an excessively high payout might suggest that the company is paying out more than it can truly afford. These high payouts are usually not sustainable and often forewarn of a dividend cut, which often triggers a decline in the stock price. To provide a baseline, the average dividend payout ratio for the S&P 500 in recent years has been about 45%.
A Growth Investor’s Perspective
Growth-oriented investors believe that a company should only consider paying a dividend if it is unable to reinvest its cash at a rate of return that is higher than the stockholder might get if they were to reinvest the dividend. The idea is that, as long as the company can earn a solid return by reinvesting earnings in the business, the investor will enjoy the accompanying appreciation in the stock price (which inevitably follows good return on invested capital).
More about the dividend payout ratio
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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