When comparing the two measures of dividends, it is important to know that the dividend yield tells you what the simple rate of return is in the form of cash dividends to shareholders, but the dividend distribution rate represents the portion of a company’s net profit that is paid out in the form of dividends. Although dividend yield is the best-known and most-reviewed term, many believe that the dividend payout ratio is a better indicator of a company’s ability to distribute dividends consistently in the future. The dividend payout ratio is closely linked to the cash flow.
Current shareholders and potential investors would do well to assess both yield and payout ratio.
Key points to remember
- Analyzing the dividends companies pay to shareholders can be important in understanding a company’s health and valuing its stock.
- Dividend yield compares the amount of dividend paid to the company’s stock price.
- The dividend payout ratio instead compares the amount of the dividend to the earnings per share of the company.
What is the dividend yield?
Dividend yield shows how much a company has paid out in dividends in a year. Return is shown as a percentage and not as an actual dollar amount. This makes it easier to see the return per dollar invested that the shareholder receives in the form of dividends.
The return is calculated as follows:
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For example, a company that paid $10 in annual dividends per share on a stock trading at $100 per share has a dividend yield of 10%. You can also see that a rise in share price reduces the dividend yield percentage and vice versa for a drop in price.
However, dividend yields can be misleading on their own. Some companies pay dividends even when operating at a short term loss. Others may pay dividends too aggressively, not reinvesting enough capital back into their business to maintain long-term profitability. This is where the dividend payout ratio can come in handy.
What is the dividend payout ratio?
This financial ratio highlights the relationship between net revenue and dividend payments to shareholders. This figure is not always prominently displayed when valuing stocks, but you can always look for income and dividend entries on the issuing company’s account. balance sheet.
In other words, the dividend payout ratio indicates whether the dividend payments made by a company make sense given its earnings. If the number is too high, it may be a sign that too little of the company’s profits are being reinvested for future operations. This casts doubt on the company’s ability to sustain high dividend payments.
The distribution rate is calculated as follows:
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Whenever possible, compare dividend payout ratios over a period of time. It is a sign of good management and financial health whether dividend payout ratios are historically stable or trending upwards at a reasonable pace.
In extreme cases, dividend payout ratios can exceed 100%, meaning more dividends were paid than there were earnings that year. Significantly high ratios are not sustainable. Companies that have stable payout ratios and relatively high dividend yields are the most attractive options for investors.