Understanding Dividend pay out & retention

DIVIDEND PAYOUT & RETENTION RATIOS

Hi there,

In this article, We look at two ratios that are connected with dividend payments. They are 1. the dividend payout ratio and 2. the retention ratio.

The dividend payout ratio measures the portion of profits that’s distributed as dividends. The Dividend Payout Ratio is calculated by dividing the annual dividends per share by the Earnings Per Share. So the formula is:

  • Dividends Per Share / EPS or

Alternatively, you can divide the dividend by net income to arrive at the same figure.

For example, If the company’s earnings per share is Rs 3 and it pays Rs 1 as dividend, the dividend payout ratio is 33%. That is, (Rs 1/ Rs 3) x 100

The next question is whether this 33% s good or bad. You may have to analyse the dividend history and the dividends declared by its peers to form an opinion.

Generally companies that pay higher dividends are large cap or so called ‘mature companies’ that doesn’t have big expansion plans anymore. A company that has massive expansion plans retains the profits with them and will not pay out much dividends.

RETENTION RATIO

Retention ratio is the exact opposite of dividend payout ratio. Retention ratio becomes important to spot growth companies.

The retention ratio shows how much is kept by the company from the profits made.  It is assumed in analysis that whatever amount the company retains, will be reinvested for growth in the company. So, it follows that, a company that retains a large portion of its income, is planning to expand its business. Generally, high retention ratios are seen in young and growing companies.

So, the formula for retention ratio is

  • Net income – dividends / Net income.

Alternatively you can deduct the dividend pay out ratio from 100 to get the retention ratio. A high retention ratio is a sign that the company is in a massive expansion mode.

A company that looks to sustain growth without any external financing would resort to increase the retention ratio.

You may like these posts:

  1. Introduction to financial ratios
  2. Understanding price to sales ratio
  3. Understanding price to book ratio

Leave a Comment