The payout ratio

THE distribution ratio corresponds to the share of profits used for the payment of the dividend. The higher this share, the more the risks to invest in dividends are high. Conversely, the lower this proportion, the greater the potential for growth in distributions. A company must balance the sharing of profits with shareholders and the share of profits that it will reinvest to ensure its development. The more it retains and reinvests, the faster it can grow. For this reason, booming sectors of activity generally have low distribution ratios while mature sectors are much more generous. Generally, It is considered that a ratio of 2/3 is already a generous compromise, and not to be exceeded. It leaves room for maneuver to companies, which prevents them from having to review their dividend policy in the event of a drop in their profits.

Since the payout ratio is equal to the share of profits paid out as dividends, we can define it using the following formula:

payout ratio = dividend / profit

By multiplying the numerator and the denominator by the price we obtain:

distribution ratio = dividend / price * price / earnings

apart from the dividend, the price is nothing other than the yield and the price/earnings ratio is better known to investors under the sweet name of PER (price/earnings ratio). We therefore obtain:

distribution ratio = yield * PER

This is where it gets very interesting because although few financial sites provide information on the distribution ratio, almost all of them give you the yield and the PER. Thus, a company that offers you a yield of 4% with a PER of 15, distributes 60% of its profits in the form of dividends. Price variations will not change anything because the price is in the numerator and the denominator. We already know that the higher the yield, the higher the distribution ratio is likely to be, and therefore the more difficult it could be to increase the dividend. Normal. But what we also see here is that the lower the PER, the lower the distribution ratio could also be, and the more room there would be to proceed with dividend increases. The ideal would in theory be a high yield, with a small PER. However, it is advisable to be very careful with certain stocks in difficulty whose price has depreciated quickly and sharply. They may trade at a more than modest P/E and show amazing yields, but they will certainly not be able to maintain them.

yield = distribution ratio / PER

This means that the yield can be very high not only because the stock is cheap, but also because the company is squandering its profit to pay its dividend. Typically, a company that pays out 100% of its profits to its shareholders and that trades at a P/E of 25, will offer a yield of 4%. By focusing on the latter, one might think that it is a good investment, however the stock is not only overvalued from an earnings perspective, but its dividend is also very likely to stagnate, or even be reduced or even cut in the coming years. Conversely, behind this same yield of 4%, there may be a company that only pays out 40% of its profits to its shareholders and that trades at a P/E of 10. The stock is cheap and the dividend has every chance of increasing in the future.

Now let's see what happens if we focus on the PER:

PER = distribution ratio / yield

As we have already seen above, we can see the strong inverse link that exists between the PER and the yield. The lower the PER, the higher the yield and vice versa. If we take the 2/3 rule (66%) for the distribution ratio mentioned above and take a yield of 3%, we obtain a PER of 22. We therefore realize that a ratio of 2/3, even with a yield that is nevertheless correct, can be the sign of an already significant valuation of the stock from the point of view of profits.

In conclusion, the distribution ratio is an indicator that complements, links and compiles the more classic and well-known ratios that are the yield and the PER. It requires us to have a more complete vision than the simple valuation from the point of view of the profit or the dividend. Any dividend investor should take this ratio into account, at least as attentively as the yield, if not more.