U.S. Markets open in 5 hrs 28 mins

Ratio Analysis: The Payout Ratio

For income investors, it is important to know what proportion of a company's earnings are being distributed as dividends. That can be found using the payout ratio, as Axel Tracy explains in "Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet."

This book is a useful source of information for new investors and for investors with a modest amount of experience. It profiles 17 different ratios and divides them into categories to help us find the right types of ratios for different situations.


The payout ratio is something of a two-for-one deal. If you know the payout ratio, you can also find the retention ratio, which refers to the proportion of earnings that is not distributed and is thus available to reinvest in company growth. The retention ratio is calculated by subtracting the payout ratio from 1.

Tracy made a point of noting, "The payout ratio is specifically based on the concept that stockholders are owners of the business and should, therefore, receive the benefits (profits) of the business."

However, he did not mention the rule of thumb that generally guides boards of directors in setting their payout ratios, which is as follows: If shareholders can earn more than a benchmark they have chosen by reinvesting, then the company will pay a modest dividend and reinvest heavily in itself. If its internal projects cannot beat the benchmark return, then they will grow their dividend payouts more aggressively and retain less for future growth.

Getting back to what Tracy wrote, he put the payout/retention question into this context:


"How you value and select your investments will determine whether you place more weight on the Payout Ratio or the 'retention ratio'. Essentially it comes down to whether you prefer to control the profits of the business yourself (i.e. take the dividend and decide what to do with the cash) or whether you prefer you investment's management to control the funds (i.e. leave the funds in the business and have management make the investments from there)."



This is the payout ratio formula:


"Payout Ratio = Dividends per Share / Earnings per Share"



For example, if the dividend per share is $0.10 and the earnings are $1.00 per share, then the payout ratio will be 10% ($0.10 / $1.00). Subtracting that 10% from 100% tells us that the retention ratio is 90%. The data for the formula can be found in company announcements, particularly in its annual returns press releases.

The dividend payout ratio can be found in the Dividend & Buy Back section of GuruFocus Summary pages. For example, this shows the payout ratio for Cisco Systems (NASDAQ:CSCO):

With a payout ratio of 0.52, Cisco is paying about half its earnings per share, 52%, in dividends. This also means it is retaining 48% of its EPS to reinvest in its own future growth.

Clicking to the Cisco payout ratio page leads to this interesting chart:

The chart tells us that Cisco began paying dividends in July 2011, and that it likely paid a special dividend (on top of the regular dividend) in July 2018.

As Tracy noted, there is no ideal payout ratio for a company; each investor will have a different ideal based on her or his preferences for income and future growth. Think of it as a trade-off. To get more income, you have to give up some future growth, and vice-versa.

Changes in the payout ratio may reflect a change in the dividend policy, the earnings per share or some combination of the two. Management controls the dividend policy, and to a lesser extent, the earnings per share.

What I personally find interesting is the relationship between investor and management. Generally, companies adopt a growth or income policy based on the type of business they're in and what their competition does.

Amazon (NASDAQ:AMZN) now has been in business for more than 20 years, but still does not pay a dividend. Jeff Bezos is convinced there is still lots of growth available for the company's platforms and wants to pour all available earnings into that potential growth.

Apple (NASDAQ:AAPL) has an interesting history with dividends, as shown in this GuruFocus chart:

It paid dividends for some time, but then stopped for about 15 years while Steve Jobs took his second turn at running the company. He famously fought off pressure to pay dividends despite the company's huge cash balances. The company did not resume dividend payments until Tim Cook took over as CEO.

Investors, on the other hand, will buy companies that reflect the type of earnings distribution they require (income, capital appreciation, or a blend of both). However, Tracy has advised there are cases in which companies enrich their dividends to broaden their shareholder appeal (and hopefully push up the share price).

He also covered the drawbacks of the payout ratio, beginning with the fact that it doesn't tell investors much about the business aside from how much money is directed towards dividends and reinvestment. Tracy wrote, "Outside of the ability to 'judge' an investment based on an individual's preferred Payout Ratio, there is not too much else to extrapolate from the ratio." I would disagree with that to some extent. The ratio does what it needs to do for investors.

Conclusion

The payout ratio is a handy tool for investors who want to know how much a company is distributing in dividends and how much it is retaining for reinvestment in its own growth. For those who know where they want to be on the dividends/reinvestment spectrum, it provides a quick answer.

It is also a window into the essential strategy of a company and its allocation of resources. Those businesses with a lower payout ratio are usually growth companies (businesses that believe they can generate higher returns than investors could achieve by taking cash and investing it elsewhere). Those with a higher payout ratio are typically mature companies with low growth expectations.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:



Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.