For a number of firms, paying dividends is a matter of pride. Many companies have been paying dividends to their shareholders for decades. A dividend is a reward, companies pay to their shareholders for investing in their equity. It is an amount paid at regular intervals to shareholders out of the company's profit.
The board of directors of the company decide upon an amount, they would like to pay the shareholders from its profits. However, it is not mandatory for every firm to pay a dividend.
Dividend payout ratio
A dividend payout ratio is the ratio of the total dividends paid by the firm in relation to its net earnings for a specific period. It is basically the percentage of earnings that have been given out to shareholders as dividends.
For example, if the company's dividend payout ratio is 20 percent. This implies that it has paid 20 percent of its total earnings as dividends to shareholders while retaining the remaining 80 percent.
The amount not paid as dividends is used for corporate purposes like expansion, research and development, repayment of the debt, operational investments, etc. This amount is known as retained earnings.
A dividend payout ratio is calculated by dividing the total dividends paid during a specified time by the earnings of the firm during that period.
Dividend payout ratio = Dividends paid / Net earnings
For example, if a firm has paid ₹20 lakh in dividends in one quarter and has net earnings of ₹1.2 crore in that period. Then the payout ratio will be 20,00,000/1,20,00,000 = 0/16 or 16.66 percent.
Another way to calculate the ratio is on the basis of per share. For this, you divide dividend per share from earnings per share.
Dividend Payout ratio = Dividends per share/earnings per share
Earnings per share = Net income/ total outstanding shares
For example, a firm has announced a dividend of ₹2 per share and has 20 lakh total outstanding shares. The earnings have come out at ₹1 crore.
Then first EPS = 1,00,00,000/20,00,000 = 5
and Payout Ratio = 2/5 = 0.4 or 40 percent
The payout ratio is 0 percent for firms that do not pay dividends and 100 percent for those that pay out their entire net income as dividends.
What does the dividend payout ratio tell us?
The dividend payout ratio reveals how much percentage of a company's earnings it is distributing amongst shareholders and how much is it retaining for the firm.
It showcases what the company prioritizes more whether it focuses more on growth or shareholders. It has to be balanced. If a company distributes more money towards its shareholders, then it is focussing more on keeping the shareholders happy and loyal and a little less on growth.
It denoted the phase a firm is in. A company in the initial stages will focus more on shareholders than growth while a more mature firm will focus more on growth while rewarding the shareholders a bit.
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It also showcases the sustainability of the dividends in the future. If the dividend payout is very high like 75 percent or even over 100 percent, then it will not be possible for the company to continue paying such high dividends for a long time. The growth of the firm will be affected and sooner the firm will either have to completely stop paying dividends to drastically reduce the payout ratio in order to sustain.
However, a one-time higher dividend can be a result of a sudden windfall received by a firm or an amazing quarter or year.
Long-term dividends with a lower payout ratio indicate a more healthy balance sheet than short-term dividends with a higher payout ratio.
So while deciding a firm on the basis of dividends, it is important that you consider the stability and consistency of dividends along with the payout ratio. A company that has a 75 percent dividend payout ratio but has only paid dividends for a few years will not be better than a company that has a 30 percent payout ratio but has been paying dividends for over a decade.