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Dividends 101 - The Beginner's Step-By-Step Overview of How Dividends Work

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Corporate Dividend Policy, Dividend Payout Ratio, and Dividend Yield
Dividend Payout Ratio and Dividend Yield Calculation Ledger

The dividend payout ratio is important because its inverse, the retained earnings ratio, allows you to calculate a stock's maximum sustainable growth rate by multiplying it by the return on equity.

Are high dividends good or bad? The answer depends upon your personality, financial circumstances and the business itself.

In Determining Dividend Payout: When Should Companies Pay Dividends?, you learned that, “a company should only pay dividends if it is unable to reinvest its cash at a higher rate than the shareholders (owners) of the business would be able to if the money was in their hands. If company ABC is earning 25% on equity with no debt, management should retain all of the earnings because the average investor probably won't find another company or investment that is yielding that kind of return.”

At the same time, an investor may require cash income for living expenses. In these cases, he is not interested in long-term appreciation of shares; he wants a check with which he can pay the bills.

 

Dividend Payout Ratio

The percentage of net income that is paid out in the form of dividend is known as the dividend payout ratio. This ratio is important in projecting the growth of company because its inverse, the retention ratio (the amount not paid out to shareholders in the form of dividends), can help project a company’s growth.

 

Calculating Dividend Payout Ratio

Coca-Cola’s 2003 cash flow statement shows that the company paid $2.166 billion in dividends to shareholders. The income statement for the same year shows the business had reported a net income of $4.347 billion. To calculate the divided payout ratio, the investor would do the following:

$2,166,000,000 dividends paid
---------(divided by)---------
$4,347,000,000 reported net income

The answer, 49.8%, tells the investor that Coca-Cola paid out nearly fifty percent of its profit to shareholders over the course of the year.

 

Dividend Yield

The dividend yield tells the investor how much he is earning on a common stock from the dividend alone based on the current market price. Dividend yield is calculated by dividing the actual or indicated annual dividend by the current price per share.

The Washington Post pays an annual dividend of $7 and trades at $910 per share; Altria Group (formerly Philip Morris) pays an annual dividend of $2.72 and trades at $49.75 per share. By calculating dividend yield, the investor can compare the amount he would earn in cash income annually from each security.

Washington Post Dividend Yield Calculation
$7.00
----(divided by)----
$910

= 0.0077 or 0.77%

Altria Group Dividend Yield Calculation
$2.72
----(divided by)----
$49.75

= 0.055 or 5.5%

In other words, despite the fact that the Washington Post pays a higher per-share dividend, $100,000 invested in its common stock would yield only $770 in annual income as opposed to the same amount invested in Altria Group which would yield $5,500. An investor interested in dividend income and not capital gains should opt for the latter, all else being equal.

 

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