What is the payout ratio?

The payout ratio is the share of a company's profits that it pays out to shareholders as dividends. The rest is retained in the business — to invest, repay debt or build reserves. It is one of the most useful quick checks on whether a dividend can be sustained: a company that pays out more than it earns cannot keep doing so for long.

The formula

\text{Payout ratio} = \frac{\text{Dividends per share}}{\text{Earnings per share}}

Because accounting earnings can be distorted by one-off items and non-cash charges, the ratio is often also calculated against free cash flow — the cash the business generates after its investments:

\text{Cash payout ratio} = \frac{\text{Dividends paid}}{\text{Free cash flow}}

A simple illustration

A company earns €4.00 per share and pays a dividend of €1.60:

\text{Payout ratio} = \frac{1.60}{4.00} = 40\%

It keeps 60% of its profits. If profits fall by a third, to about €2.67 per share, the ratio rises to about 60%: the dividend is still covered and can probably be maintained. A company paying €3.60 out of the same €4.00 — a 90% payout ratio — would be paying out a third more than it earns after the same fall.

How to read it

Payout ratio	Typical reading
under 30%	lots of room common for growing companies
30–60%	balanced typical of mature companies
60–80%	high common for utilities, telecoms and real estate
over 100%	paying out more than is earned not sustainable for long

It depends on the industry. Stable businesses with predictable cash flows, such as utilities, can sustain higher ratios than cyclical ones.
A rising ratio is a warning sign when earnings fall while the dividend stays the same.
A low ratio is not automatically better. A company that retains most of its profits should be investing them at good returns; otherwise shareholders might be better off receiving the cash.

Limits

One bad year distorts it. A temporary drop in earnings can push the ratio above 100% without threatening the dividend; several years, or cash flow, give a better picture.
Share buybacks are another way of returning cash to shareholders, and the dividend payout ratio leaves them out.
It says nothing about the balance sheet. A company with heavy debt may have to cut its dividend even at a moderate payout ratio.

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