Every company gives a part of its earnings or a portion of its cash flow to its shareholders. This ratio is called the payout ratio. The payout ratio is the ratio between the dividend paid by the company and the income earned during a particular period. The payout ratio is denoted in percentages and implies the proportion of the earnings given out to shareholders. It can also be used as an indication of the retained earnings of the company.Highlights
Suppose a company JD limited announces a dividend of rupees 2,000 INR for the financial year 2020. Its net profit as per the income statement is rupees 10000 INR. In this case, the ratio will be 2000 / 10000 or 0.2 or 20%
In the above example, we see that if a company earns a profit of a 100 and gives out 20 in the form of dividends, it means that it retains 80 in the form of its retained earnings. Thus we can say
dividend payout ratio + retention ratio = 1 or
1 - dividend payout ratio = retention ratio
The payout ratio is a very significant factor that an investor considers before parking money in any investment. While considering payout ratios a few other things that an investor might want to consider. One factor is the maturity stage of the company. For instance, if a company was founded in the year 2020 and in the year 2021 it distributes 30% of its net income as dividends, then it is not a very good sign. It would somewhat be frowned upon- this is because, in the initial years, it is good to retain the earnings to supplement the growth of a new business. On the other hand, if the company is mature, then a reasonable payout ratio would be considered an indication of solid performance and good management of the company and would attract investors to invest in the company's shares.
Another factor when judging a company using its payout ratio is the industry that the company belongs to. Some market sectors are constantly evolving- they need to invest heavily in research and development to even survive in the market. One such industry is the technology industry. Due to the heavy investments required for frequent upgradation, the companies may not give out high dividend payments. Often technology stocks also give zero dividends. While the dividends or payout ratio may be zero, the company may be performing well, and the market value of its shares may be improving because of the continuous evolution in its technology and performance.
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The dividend payout ratio is helpful for investors to decide what kind of returns they can expect. The total shareholder return is a total of the dividends and capital returns that they receive. A high payout ratio is indicative of lower profits being ploughed back. Investors looking for regular income can eye such shares. On the other hand, companies with a low payout ratio register a reasonable growth rate. So investors eyeing capital gain could look at such shares. Thus we see how the knowledge of payout ratios help investors in choosing their investments. However, like any other financial metric, the payout ratio alone may not be the best indicator. The fundamental analysis of the company must be glanced at before an investor takes a final call.
The retention ratio is the part of earnings that companies do not distribute to the shareholders but instead keep back in the organisation as retained earnings. The retention ratio is impacted by the payout ratio and vice versa. They are indirectly related, i.e. if one increases, the other decreases.
Retention ratio = (Net income – dividend distributed)/ Net income
Or Retention ratio = retained earnings/ net income
The retention ratio differs from one company to the other. The retention ratio is very high for new companies- being in the nascent stages, a business needs more research and development, the latest technology and machinery. Similarly, biotechnology companies often have a high retention rate because technologies and dimensions of the health sector are ever-evolving. While on the other hand, mature companies have investors who have high dividend expectations, there the payout ratios are high.
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Retention ratios keep fluctuating from time to time. As companies grow, they may be able to pay out more. Cyclical companies may decide on payout depending on the external market forces. Blue-chip companies may either extend increasing payouts or constant payouts over time.
No optimal or golden payout ratio exists. Any such prescription is highly subject to the stage of growth of a business, the stage of the business cycle in the economy, the expansion goals of a company, the expenses, revenues and contingencies experienced during an accounting period, investor sentiments, market sector conditions, project-specific profit plough back requirements etc. As a result, the optimal rate for one company may not be helpful for another. Similarly, a company's optimal rate today may differ from its optimal rate a decade later.