Dividend yield and dividend payout ratio are the two most common ratios that are calculated to test the dividends paid by the company (dividend and capital gain are the two components of an investment return in stock).
Dividend Yield
Dividend yield is a percentage that shows the return, through dividends, shareholders receive for every dollar invested into the company.
Dividend yield formula = annual dividends per share/price per share
EXAMPLE
Company A Dividend per share: 5 Euro Price per share: 40 Euro
Company B Dividend per share: 6 Euro Price per share: 60 Euro
Company A Dividend yield: 5/40= 12.5%
Company B Dividend yield: 6/60=10%
The two companies operate in the same mature sector.
If we suppose that the two companies will not guarantee returns from capital gain, an investor should prefer to buy stock of company A because it offers a major return.
However, stock price changes every day and dividend payments to common stock can change from one year to another; for these reasons, investors need to analyse the financial statement and calculate other ratios before to finally decide.
Dividend Payout Ratio
Dividend Payout Ratio (DPR) measures the percentage of net income that is distributed to shareholders in the form of dividends. DPR formula is as follows:
Total dividends/Net income
or
Dividends per share/Earnings per share
EXAMPLE
Company A reports a net income of 75,000 Euro for the year, and it declares and issues dividends for 5,000.
DPR: 5,000/75,000= 6,67%
Company A is paying out 6,67% of its net income to shareholders; the company keeps the remaining 83.33% of net income.
When Dividend Payout Ratio is used
When an investor buys a stock to take advantages of its dividend return, he needs to test its sustainability (the ability of the company to pay this amount of dividend also in the future); dividend payout ratio and forward payout ratio help on this.
If we consider the previous example, the company distributes only 6.67% of the net income; this means it has generated enough profit to pay the dividends guarantee to the shareholders.
However, if a company’s payout ratio is over 100%, the company is returning more money to shareholders than it is earning. This should raise a red flag to the investors also if it can not be necessarily a bad sign; if the company endures a bad year, it can decide not to suspend dividend payment if it believes it will be able to return as normal the following year.
To check only dividend payout ratio is not sufficient; it is important also to consider future earnings expectations and calculate a forward payout ratio to complete the analysis.
Furthermore, long term trends in the payout ratio also matter. A steadily rising ratio could show a healthy, maturing business but a spiking one could mean the dividend is heading into unsustainable territory.
High & Low Dividend Payout Ratio
Dividend Payout Ratio usually depends on the sector the company operates.
EXAMPLE
High-tech companies usually distribute little to no returns in the form of dividends because they invest the major part of their net income in developing the business.
High Tech companies usually offer a low level of dividend payout ratio but possible high returns as capital gain.
Utility companies rarely felt the need to commit a high percentage of their earnings into business expansion.
Utility companies usually distribute a large part of their net income into dividend with a high rate of dividend payout ratio; however, these companies normally offer a low return as capital gain.