After tax and payment of preference dividend, all the leftover profit is not distributed among the equity shareholders as dividend. Rather, a part of it is retained in the business and rest amount is distributed among the equity share holders. Now, the dividend payment ratio depicts what percentage of profit after tax and preference dividend has been paid to the equity share holders in the form of dividend. It is also called as payout ratio which is calculated as under:
Dividend Payout Ratio = (total dividend paid to the equity share holders/ earnings per share) x 100
Or D/P ratio = (DPS/EPS) x 100
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Dividend Payout Ratio builds a relationship between two things, what company is returning to its shareholders and what is being kept/ retained in the business for growth, paying off debt or added to cash reserves. The kept portion of the profit is termed as retained earnings. The ratio is expressed in percentage, hence when we subtract the D/P ratio from 100, we get percentage of profit retained in the business itself.
Interpretation of Dividend Payout Ratio
The very primary thing behind the concept of Dividend Payout Ratio is the maturity of the firm/ company. If the company is in its growing stage or in the phase of expansion/ diversification, then it will be having a lower Dividend Payout Ratio. This is because, the company needs to keep profits as retained earnings since funds are required for expansion.
Now, for a well flourished company, it is very unlikely that it cuts dividends of the investors as cutting down the dividends will drop down the stock price and the faith of the investors in the company will be hampered. A good Dividend Payout Ratio ensures investors’ faith and hence helps in overall growth of the company.
How to Apply Dividend Payout Ratio?
Sometimes companies have Dividend Payout Ratio more than 100% which means that it is paying dividend to the investors more than the earnings which is cut down or even stopped eventually. Investors often see long term trends in Dividend Payout Ratio as n indication of financial health and maturity of the company.
Dividends are “Industry specific” as they vary widely with the industry. In addition, the company always does not have a single way of returning to the investors in the form of dividends. Thus, this ratio must be applied relevantly to get best results.