The term dividend payout ratio refers to a measure of the dividends paid to shareholders relative to the net income generated by the company. The dividend payout ratio is an important profitability metric, and one that's closely watched by investors that rely on the payment of dividends as a source of household income.
Dividend Payout Ratio = Cash Dividends / (Net Income - Preferred Dividends)
Alternatively, this ratio's formula can be stated as:
Dividend Payout Ratio = Dividends per Share / Earnings per Share
Profitability ratios allow the investor-analyst to understand how well a company performed during the year. Generally, profitability metrics are based on information found on the income statement, although several do rely on information from the balance sheet too, such as return on assets.
Common stocks can provide a return to their investors in two ways. The price per share can increase over time, and the common stock can pay a dividend. Companies in mature industries tend to have fewer opportunities to invest earnings back into the company. For this reason, these companies tend to have higher dividend payout ratios than faster growing companies.
Since companies with higher ratios are valued by investors seeking a steady source of income, a reduction in the dividends paid is seen as a negative. For that very reason, these same investors will pay close attention to the company's dividend payout ratio. Investors purchasing common stocks for income purposes will also track a closely related metric: dividend yield.
The Board of Directors for Company A recently declared a dividend of $1.42 per share. Company A's earnings per share was $2.52. The dividend payout ratio for Company A is calculated as follows:
= $1.42 / $2.52, or 56.3%