Coming to terms: Payout ratio
High payout ratios leave companies with little flexibility regarding what they can do with their cash.
Q: What’s a “payout ratio”?
A: It’s the percentage of a company’s earnings (net income) paid out to shareholders as a dividend.
For example, tobacco giant Altria’s trailing earnings per share (EPS) is $1.92, and its annual dividend is currently $1.76 ($0.44 per quarter). Divide $1.76 by $1.92, and you’ll get 0.92, or a payout ratio of 92 percent.
High payout ratios such as that leave companies with little flexibility regarding what they can do with their cash.
That can be OK if a firm is big and established and doesn’t need to reinvest much in the business.
Sometimes reinvested earnings would return less than shareholders could get investing the payout on their own, too.
Still, a steep payout ratio can be a red flag. If a company’s ratio is 160 percent, for example, it will have to dig into reserves to pay its dividend, something it can’t keep up forever. It may have to reduce its dividend.
Low payout ratios are best, as they suggest lots of room for dividend increases.