Evaluating the dividend payout ratio lets us focus on companies that have enough internal growth to give us those dividend increases that we want each year.
As we know, these dividend increases will help our portfolio income beat inflation over time and provide us with a growing income in retirement.
How To Calculate The Payout Ratio
The dividend payout ratio is calculated by dividing the dividend paid by the net income per share:
Dividend Paid/Net Income per Share = Dividend Payout Ratio
Why The Payout Ratio Is Important
For the most part, we should be looking for stocks that have a dividend payout ratio somewhere between 40-60%. This allows a good portion of the profits to be paid to the shareholder as well as allowing for some of the profits to be plowed back into the company to create more internal growth.
The higher the dividend payout ratio, the less profits are invested back into the business to create future growth. In our dividend growth strategy, we look for companies that invest back into the business in order to create more growth that will allow for another increase in the dividend.
Can Companies Pay Out More Than They Earn?
As we mentioned before, dividend payout ratios of greater than 100% are possible, but very difficult to sustain and significantly hamper the growth of the business.
In tough economies temporary increases in the dividend payout ratio can be common because it can be very damaging to a stock if the company suspends or lowers the dividend.
High yields may look appealing at first, but we must ensure that the dividend is both sustainable and able to grow.