Dividend Payout Ratio

Whatever.com has earnings. Big earnings. A hundred million dollars worth of earnings this year from sales of a whole lotta whatevers.

The board green lights a dividend payment of 40 million bucks. That is, the company will pay 10 million dollars to its common shareholders of record 4 times in this next year. The payout is 40 million because it’s, uh… paid out. And yeah, clever titling was never a Thing on Wall Street. The payout ratio is 40 over 100...or 40 percent.

So why does the payout ratio even matter? Well, companies hate having to cut their dividends…and they love raising them. In the former, stock prices usually crash; in the latter, they usually go up. And companies love it when their stock prices go up. Duh.

So what would happen if Whatever.com stumbled, and its earnings tumbled, and then shareholders mumbled that the earnings payout ratio had, uh… crumbled? That is…what if the earnings of whatever.com went down next year to only 50 million?

Hm. Problem. Because now the payout ratio is 80 percent (40 over 50). Very difficult situation. The company thought it would have tons of earnings to cover its dividend at the 40 million level more or less forever. But clearly it did not.

So now what?

Well…if earnings recover and go back to 100 million on their way to 300 million, then life is grand. No sweat. No heavy decisions to be made. But what if earnings fall further to be only 30 million the following year? Well, then whatever.com has to either borrow money or deplete its cash to cover or pay its dividend...in which case the payout ratio would potentially be over 100%, meaning that if earnings were 30 mil and the dividend was to 40 mil, then the payout ratio would be 40 over 30, or 133%. Ouch. Can’t do that for very long without going bankrupt.

So payout ratios matter...because they give a sense for how certain that dividend is to continue.

If the ratio is low, odds are good the company could certainly afford to raise the dividend, or at least not cut it…for a long time. If the ratio is high, your bottom line may soon be, uh…bottoming out.