The Dividend Payout Ratio (DPR) is another super important statistic to you as a dividend investor.
This ratio tells you what percentage of a company’s profit is being paid out in dividends. If the company pays out too much, it won’t have enough to invest for growth. We need growth for those yearly raises we crave so much!
There are some exceptions such as REITS but we’ll cover those later.
So how do you calculate a DPR?
DPR = DIVIDENDS PER SHARE (DPS)/EARNINGS PER SHARE (EPS)
Let’s dive into an example to clear things up...
Say XYZ Financial (our favourite company!) reported earnings for the fourth quarter of $10 billion dollars (or $1.25 in earnings per share). They also paid a dividend to their shareholders in the amount of $0.63 per share.
Using the above equation.... $0.63/$1.25 = 0.504 or 50%
So XYZ paid out 50% of their net earnings in dividends. This is great because they have 50% of the profit remaining to reinvest for growth.
Growth in earnings equals growth in dividend payment. That’s music to our bank accounts!
As mentioned previously, you`ll learn later exactly what our benchmarks are for selecting the best dividend paying stocks. For now let`s keep building you a solid base of knowledge.
So why is the DPR so important?
As dividend growth investors we want to make sure our dividend payouts are safe and sustainable for the long-term. In business, many things can happen to a company that will impact earnings in the short term.
So the DPR should leave a margin of safety in case the company hits a temporary rough patch. This margin of safety is what’s left of earnings after paying out dividends (or alternatively, 1 - DPR = Margin of Safety).
For example, say XYZ with their current 50% payout ratio, suffers a temporary decline in revenue because of an unusual string of loan defaults. Because their payout ratio is so low, the dividend payment will not be in jeopardy and can still be increased... phew!
This may increase the DPR to 55% or so but over time management will bring it back down to normal levels.
So there you have it... you passed the lesson on Dividend Payout Ratio and now you’re ready for Return on Equity.