Dividend Payout Ratio
Dividend Payout Ratio
A financial metric showing the percentage of earnings paid to shareholders as dividends, calculated as Dividends per Share ÷ Earnings per Share (or Total Dividends ÷ Net Income). A high payout ratio (70-90%) may indicate limited growth reinvestment or mature company status, while a low ratio (20-40%) suggests the company is retaining earnings for growth.
A company with $5.00 EPS paying $2.00 per share in annual dividends has a 40% payout ratio ($2.00 ÷ $5.00). This suggests the company retains 60% of earnings for reinvestment while returning 40% to shareholders.
Students often confuse payout ratio with dividend yield. Payout ratio = dividends as % of earnings (company perspective), while yield = dividends as % of stock price (investor perspective). A high payout ratio is not always good; it may indicate limited growth opportunities or unsustainable distribution.
How This Is Tested
- Calculating the dividend payout ratio given earnings per share and dividends per share
- Comparing companies with different payout ratios to assess growth vs. income focus
- Determining whether a high payout ratio indicates financial strength or potential dividend cuts
- Understanding the relationship between payout ratio, retention ratio, and sustainable growth
- Distinguishing between dividend payout ratio and dividend yield in suitability scenarios
Calculation Example
Dividend Payout Ratio = Total Dividends ÷ Net Income (or Dividends per Share ÷ EPS) - Identify total dividends: $4 million
- Identify net income: $10 million
- Calculate payout ratio: $4M ÷ $10M = 0.40 = 40%
- Alternative: EPS = $10M ÷ 2M shares = $5.00; DPS = $4M ÷ 2M shares = $2.00
- Verify: $2.00 ÷ $5.00 = 0.40 = 40%
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Payout Ratio Formula | Dividends per Share ÷ Earnings per Share | Also calculated as Total Dividends ÷ Net Income |
| Retention Ratio Relationship | Retention Ratio = 1 - Payout Ratio | Percentage of earnings retained for reinvestment |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Sarah, a 62-year-old retiree seeking income, is comparing two dividend-paying stocks. Company A has a dividend payout ratio of 80% and stable earnings in the utility sector. Company B has a 25% payout ratio and operates in the technology sector with high earnings growth. Both currently yield 4%. Which statement best describes the suitability considerations for Sarah?
A is correct. For Sarah, a retiree seeking income, Company A's high 80% payout ratio in a stable utility sector indicates a mature company committed to returning most earnings to shareholders. Utilities typically have stable cash flows, making the high payout sustainable. This aligns with her income needs.
D contains a misconception: while an 80% payout ratio leaves less cushion for dividend cuts if earnings decline, in a stable utility sector this is standard practice and not necessarily a concern. B is incorrect because a low payout ratio benefits growth investors, not income-focused retirees. Company B is likely reinvesting for growth rather than maximizing distributions. C is incorrect because payout ratio matters for income sustainability. Two stocks with the same yield can have very different payout ratios, affecting dividend safety and growth potential.
The Series 65 exam tests your ability to evaluate dividend payout ratios in the context of client suitability. Understanding that high payout ratios suit income investors (if sustainable) while low ratios suit growth investors is critical for making appropriate recommendations based on investment objectives and life stage.
The dividend payout ratio measures which of the following?
B is correct. The dividend payout ratio measures the percentage of earnings (net income) that a company distributes to shareholders as dividends, calculated as Dividends per Share ÷ Earnings per Share.
A describes dividend yield (dividends ÷ stock price), not payout ratio. C also describes dividend yield using different wording. D describes total return, which includes both income (dividends) and capital gains, not the payout ratio. The key distinction is that payout ratio relates dividends to earnings (company fundamentals), while yield relates dividends to stock price (market valuation).
The Series 65 exam frequently tests your ability to distinguish between dividend payout ratio and dividend yield. These are commonly confused metrics: payout ratio shows what percentage of earnings are distributed (company perspective), while yield shows what percentage return investors receive on their investment (investor perspective). Understanding this distinction is essential for fundamental analysis questions.
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Access Free BetaXYZ Corporation reports earnings per share of $8.00 for the fiscal year and declares an annual dividend of $3.20 per share. What is the company's dividend payout ratio?
B is correct. Calculate: Dividend Payout Ratio = Dividends per Share ÷ Earnings per Share = $3.20 ÷ $8.00 = 0.40 = 40%. This means XYZ distributes 40% of its earnings to shareholders and retains 60% for reinvestment.
A (25%) incorrectly calculates $2.00 ÷ $8.00, using the wrong dividend amount. C (60%) represents the retention ratio (1 - 0.40), which is the percentage of earnings retained, not distributed. D (250%) incorrectly inverts the formula, calculating $8.00 ÷ $3.20, which is a common mathematical error when students confuse which number goes in the numerator versus denominator.
Dividend payout ratio calculations appear regularly on the Series 65 exam. The key is remembering that dividends go in the numerator and earnings go in the denominator (what you pay out ÷ what you earned). Confusing this with the retention ratio or inverting the formula are the most common errors.
All of the following statements about the dividend payout ratio are accurate EXCEPT
C is correct (the EXCEPT answer). A payout ratio above 100% means the company is paying out MORE in dividends than it earned in net income, which is NOT sustainable long-term. The company must use cash reserves, borrow funds, or sell assets to maintain the dividend, indicating potential financial stress, not strength. This is often a red flag for potential dividend cuts.
A is accurate: High payout ratios (70-90%) typically characterize mature companies in stable industries (utilities, consumer staples) that generate consistent cash flow but have fewer growth opportunities requiring capital reinvestment. B is accurate: Low payout ratios (20-40%) indicate growth-focused companies retaining most earnings to fund expansion, R&D, or acquisitions. D is accurate: Payout Ratio + Retention Ratio = 100% because earnings are either distributed as dividends or retained in the business.
The Series 65 exam tests your ability to interpret payout ratios in the context of financial health and sustainability. Understanding that payout ratios above 100% are unsustainable warning signs, not strengths, is critical for making appropriate investment recommendations and identifying risks in dividend-paying securities.
A company has net income of $20 million, pays total dividends of $12 million, and has 4 million shares outstanding. Which of the following statements are accurate?
1. The dividend payout ratio is 60%
2. The retention ratio is 40%
3. The earnings per share is $5.00
4. The dividends per share is $4.00
B is correct. Statements 1, 2, and 3 are accurate, but statement 4 is false.
Statement 1 is TRUE: Payout Ratio = Total Dividends ÷ Net Income = $12M ÷ $20M = 0.60 = 60%.
Statement 2 is TRUE: Retention Ratio = 1 - Payout Ratio = 1 - 0.60 = 0.40 = 40%. Alternatively, the company retains $8M of the $20M earned: $8M ÷ $20M = 40%.
Statement 3 is TRUE: EPS = Net Income ÷ Shares Outstanding = $20M ÷ 4M shares = $5.00 per share.
Statement 4 is FALSE: DPS = Total Dividends ÷ Shares Outstanding = $12M ÷ 4M shares = $3.00 per share, not $4.00. This is a common calculation error when students don't carefully divide the correct numerator by the share count.
The Series 65 exam tests your ability to calculate multiple related metrics from the same financial data. Understanding the relationships between payout ratio, retention ratio, EPS, and DPS is essential for comprehensive fundamental analysis and making informed recommendations about dividend-paying securities.
💡 Memory Aid
Think "Payout = Pay OUT of what you Earned": Dividends per Share ÷ Earnings per Share. High ratio (70-90%) = mature income company paying most profits to shareholders. Low ratio (20-40%) = growth company keeping profits to reinvest. Above 100% = danger zone (paying more than earned).
Related Concepts
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