Investments

What Is A Good Dividend Payout Ratio

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

One of the most popular ways to generate passive income is through dividend investments. To this purpose, investors should prioritize finding firms with both substantial dividends and steady growth.

This allows the investor to profit from rising share prices and receive a portion of the company’s profits in the form of dividend payments once or twice a year.

Dividend investing is common among both seasoned investors and those new to the market because of the potential for profit and appreciation in value it offers.

Inexperienced investors frequently make the error of pursuing huge yields without fully appreciating the implications of doing so.

What Is the Retention Ratio and Dividend Payout Ratio?

When evaluating an investment, several different ratios are used. The dividend payout ratio and the retention ratio are two important measures for stock investors interested in dividends.

Dividends are distributed from the company’s profits. After all, the business would have to dip into reserves or take on debt if dividend payments ate up a larger percentage of profits than the firm expected.

A quick look at the dividend payout ratio and the retention ratio can tell investors a lot about the company’s approach to allocating profits. The dividend payout ratio measures how much of a company’s profit is distributed to shareholders, whereas the retention ratio measures how much of a company’s profit is maintained to finance expansion plans.

To illustrate, suppose firm XYZ made $100 million in net income and distributed $20 million to shareholders, opting to keep $80 million for future investment in the company’s growth. This would result in a dividend payout ratio of 20% and a retention ratio of 80%.

What Is a Good Dividend Payout Ratio?

Sure, as a shareholder, you want to cash in on the highest dividends available. That’s not exactly right, either.

Investing entails putting money to work so that it can earn more money over time through the magic of compound interest. Dividends are a distribution of wealth and should be seen as such.

It is well-known that when a company pays dividends to its shareholders, the stock price falls. With only $80 million in cash on the books, a stock that has $100 million in cash would be more appealing.

Prioritizing dividends above growth can drastically lower the long-term worth of an investment since there is always a cost connected with earning a dividend.

Therefore, what is an appropriate dividend payment ratio? Your investment strategy, risk tolerance, and financial goals should all play a role in determining the best response to that question. The sweet spot for dividend investors is a payout ratio of between 30% and 55%. 

We classify payout percentages between 30% and 55% as low and high, respectively.
However, both high and low payout percentages have their advantages and disadvantages.

Pros and Cons of a Low Payout Ratio

A low dividend payout ratio is desirable by whom? Don’t you want to make money by investing? In some cases, even a little dividend payment might boost a portfolio’s overall results.

Pros

Reducing the payout ratio can help in a number of ways. It is in the best interest of the firm for the majority of its profits to be reinvested rather than distributed as huge dividends to shareholders. The following are among the most crucial factors to think about:

  • Making money requires spending money. At first look, it may seem terrible for investors if a company’s profits were not shared at all or were shared in a very tiny amount. Making money, however, is not free. Cutting-edge, publicly listed corporations invest heavily in R&D, increasing the value of their assets and increasing the likelihood that they will dominate their markets in the future. Therefore, seemingly pricey innovation frequently becomes the goose that lays the golden eggs later on.
  • Remediation of the Balance Sheet. Any company that wants to succeed on the stock market needs a solid balance sheet. Companies can improve their financial health by either reducing their dividend payments or eliminating them altogether. Increased investor confidence and a better stock price result from a company’s improved capacity to withstand a crisis by increasing its cash reserves or decreasing its costly debts.
  • Acquisitions. Investing in an acquisition is a risky but possibly lucrative move. When larger firms buy out smaller ones in the same industry, they can leverage their existing resources to drive down operating expenses at the acquired firm while also absorbing the acquired firm’s goods, technology, and customer base to increase their own income. Investment capital set aside from a company’s profits and used toward accretive acquisitions is money effectively spent in most cases.

Cons

There are benefits to having a low dividend payout ratio, but there are also some negatives.

  • Small Dividends Paid. Dividend payments tend to be modest when the payout ratio is low. A low payout ratio is not ideal if you are an investor seeking to profit from stock dividends.
  • It might mean that money is tight right now. Companies trading on public exchanges are not obligated to provide dividends. As a matter of fact, there are many of them that don’t bear fruit at any of the achievable degrees of accomplishment. Low payout ratios are common for firms that reinvest the vast majority of their net earnings in order to expand their business. Sometimes businesses just don’t generate enough revenue to justify dividend payments. Therefore, before investing in a company with a low dividend payout ratio, make sure the firm is founded on a solid financial basis by reviewing its balance sheet, cash flow statement, and other financial data.

Pros and Cons of a High Payout Ratio

There is no denying the advantages of a dividend payout ratio that is quite high. Remember that a high payout ratio indicates generous dividend payouts. However, there are drawbacks to anything beautiful, and a high payout ratio might be no exception.

Pros

A high payout ratio causes excitement among investors for a number of different reasons. Among the most notable are:

  • Significant Dividend Payouts. Some investors like high payout percentages for the simple reason that it predicts future dividend increases. A high payout ratio is desirable if dividend income generation is your major investment objective.
  • Stable finances. A high dividend payout ratio is typically indicative of solid financial health. Companies are not obligated to distribute dividends to shareholders. If the company decides to pay a large dividend, it probably has a solid financial foundation and a compelling cash flow stream to support the move.
  • Possibility of Further Investment. Buy dividend stocks and reinvest your dividend payments, as this is how traditional investors advise you to maximize your long-term gains. More of your net income can be reinvested as dividends if you obtain a greater dividend payout as a percentage of your overall net income.

Cons

A high dividend payout ratio has numerous potential benefits, but it may also be cause for concern. Stocks with a high payout ratio may seem appealing at first glance, but investors should be wary of a few things before making a purchase:

  • Complete Penetration of the Market. Market leaders in oversaturated sectors often pay out obscenely high dividends, doling out most or all of their net profits to shareholders. When a corporation has achieved market dominance and established firm control over a sizable portion of the market, it may confidently distribute a considerable portion of its profits to its shareholders.

    In one sense, that’s fantastic news, but in another, it suggests that the market’s full potential for expansion has already been realized. If you currently have such a large proportion of a market that you have trouble finding a worthwhile way to reinvest your profits, you probably can’t gain any more ground on the competition. Since you only participate in market expansion as a whole, you miss out on significant expansion prospects available to more modest businesses. For this reason, a high payout ratio often does not bode well for future share price growth.
  • Not being creative enough. Without setting aside some of their earnings for research and development, businesses risk falling behind the times and eventually going out of business. Once they stop innovating, even successful businesses fail. Consider BlackBerry, once the dominant player in the smartphone industry but now a trailing tech firm that has shed tens of billions of dollars in market value over the previous decade. If a company’s dividend payout ratio is high, it might mean that it is becoming complacent in its position as market leader.
  • Unfortunately, recessions are common. Bear markets and economic recessions are nothing new. Earnings in the past are not necessarily an indicator of future earnings, and economic swings play a significant part in this phenomenon. If a corporation doesn’t put aside enough of its net earnings during the good times, it might not be able to weather a downturn without incurring heavy losses for its shareholders.

Bottom Line

Intriguing ideas like dividends are being discussed. Investors can have their cake and eat it too if a firm has both significant share price rise and dividend payments. But there aren’t too many equities out there with a stellar track record of both dividends and price appreciation.

While dividend stocks may be part of a diversified portfolio, putting too much emphasis on them alone could result in poor performance or even a loss.

When deciding whether or not to invest in a firm, it’s important to take a close look at its financial health, its history and prospects for innovation, and its ambition to establish or preserve its position as market leader.

More people will become millionaires in the future thanks to dividend investment. The key to being the next stock market success story may lie in making informed investments and adhering to a dividend investing plan.

Curated posts

Someone from San Diego, CA just viewed Best Online Colleges for Business Degrees