Dividend Payout Ratio

What is the dividend payout ratio and why is it important?

The dividend payout ratio of a company measures the amount of dividends paid by a company in relation to the net earnings generated by a company. In other words the dividend payout ratio of a company essentially measures the percentage of net profits paid by a company to shareholders. 

Dividend Payout Ratio = Dividend Per Share / Net Income Per Share

For example if Sasol declares a dividend per share of R5 for the 2022 financial year and the company generated a net income per share of R20 for the 2022 financial year the dividend payout ratio will be 25% and is calculated as follows:

Dividend Payout Ratio = R5 / R20 

                                        = R25% 

Net profits that are not paid out as dividends by the company is money retained in the business and is referred to as retained earnings. 

The dividend payout ratio can help investors identify companies that align with their investment goals. When shareholders invest in a company, return on their investment comes from two sources: dividends and capital gains. 

• A high dividend payout ratio means that the company is reinvesting less money back into its business, while paying out relatively more of its earnings in the form of dividends. Such companies tend to attract income investors who prefer the assurance of a steady stream of income to a high potential for growth in share price.
• A low dividend payout ratio means that the company is reinvesting more money back into expanding its business. By virtue of investing in business growth, the company will likely be able to generate higher levels of capital gains for investors in the future. Therefore, these types of companies tend to attract growth investors who are more interested in potential profits from a significant rise in share price, and less interested in dividend income.

The dividend payout ratio is not intended to assess whether a company is a good or bad investment. Rather, it is used to help investors identify what type of returns dividend income vs. capital gains a company is more likely to offer the investor. It is also important to note that there is no optimal dividend payout ratio. You should however also be weary of a company with a dividend payout ratio that is close to 100% as the company could face financial trouble if they do not retain enough income to meet operational needs, interest payments and to pay creditors.