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Payout ratio

The payout ratio is the amount of net income that is paid out as dividends to common shareholders, expressed as a percentage.

<math>Payout\ ratio = \frac{dividends\ paid}{net\ income}</math>

Expanded Definition

The size of the payout ratio is often dependent on the growth stage the company is in. For a young, rapidly growing company, the payout ratio is going to be small (or zero) as the company keeps most or all of its earnings to reinvest in growing the business. As the company matures and begins to pay a dividend, the payout ratio increases.

The ratio is also dependent on the industry in which the company operates. Utilities, for instance, don't grow very fast and have relatively large payout ratios. Computer hardware companies, on the other hand, always need money for research & development and are reinvesting in themselves, so the payout ratio is quite small.

In other words, a company must balance between sharing profits with shareholders through dividends and retaining profits to reinvest in the business to grow the company. Obviously, the more it retains and reinvests, the more rapidly the company can grow.

Analysts can calculate the implied growth rate that the company can maintain using the payout ratio and the return on equity.

<math>Implied\ growth\ rate = (1 - payout\ ratio) * (return\ on\ equity) = (retention\ ratio) * (return\ on\ equity)</math>

For instance, if the payout ratio is 60% and the return on equity is 20%, the implied growth rate is 8%.


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