It is preferable to choose stocks with a lower payout ratio in order to be sure that you hold businesses that can continue to pay dividends
The ratio of the company’s total dividend payments to its net earnings for a given time period is known as the dividend payout ratio. It is essentially the proportion of earnings that have been distributed as dividends to shareholders.
As an illustration, if the company’s dividend payout ratio is 20 percent, this suggests that it has kept the remaining 80 percent of its earnings after paying out 20 percent as dividends to shareholders. Dividend payout ratios are derived by dividing the total amount of dividends paid during a specific time period by the company’s earnings during that particular time.
The money that is not distributed as dividends is put to use by the company for things like expansion, R&D, debt repayment, operational investments, etc. We refer to this sum as retained earnings.
A common mistake by rookie shareholders is to choose stocks with the highest dividend yields. They believe that because of the increased yield, they will be able to generate bigger returns. That is regrettably not always the case.
In many stocks with high yields, the dividend payment ratio is similarly high. Since they have fewer retained earnings, they are less likely to raise the dividend payment amount. As a result, they have less freedom to raise their payout ratio.
What is preferable?
It is preferable to choose stocks with a lower payout ratio, even if it means forgoing potential yield, in order to be sure you hold businesses that can continue to pay dividends. These businesses have more financial freedom to make investments in raising earnings, which will allow them to raise dividends.
Industry-specific dividend payout ratios frequently differ. Higher dividend payout ratios are sometimes seen in businesses that operate in mature, slower-growing industries that produce large amounts of relatively consistent cash flow. They don’t need to hold onto as much cash to finance their company’s operations for things like opening more stores or constructing a factory.
A good dividend payment ratio for financially viable companies in these sectors is less than 75 percent of their earnings. On the other hand, companies in fast-growing industries, those with more irregular cash flows, and those with thicker balance sheets require a lower dividend payment ratio and it should ideally be under 50 percent.
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