Target Payout Ratio' A target payout ratio is a measure of what size a company's

dividends should be. Firms generally determine their target payout ratio through a stable
dividend policy tied to long-run, sustainable earnings

The payout ratio is a key financial metric used to determine the sustainability of a company's
dividend payments. A lower payout ratio is generally preferable to a higher payout ratio, with
a ratio greater than 100% indicating the company is paying out more in dividends than it
makes in net income

DEFINITION of 'Target Payout Ratio'

A target payout ratio is a measure of what size a company's dividends should be. Firms
generally determine their target payout ratio through a stable dividend policy tied to long-run,
sustainable earnings. They are usually reluctant to increase dividends unless a reversal is not
expected in the near future.
Target Payout Ratio = (dividends per share / earnings per share)
Firms strive for a stable dividend policy to align their dividend growth rate with the
company's long-term earnings growth rate to provide a steady dividend over time. A company
with a stable dividend policy can choose to use a target payout ratio adjustment model to
gradually move towards its target payout.
Expected dividend = (previous dividend) + [(expected increase in EPS) x (target payout
ratio) x (adjustment factor)]
where: adjustment factor = (1 / # of years over which the adjustment in dividends will take
place)
BREAKING DOWN 'Target Payout Ratio'
A company with a residual dividend model, where the dividends are based on the amount of
residual earnings left over after the company pays all its expenses and obligations, can also
use a target payout ratio.
The following steps are followed to determine the target payout ratio:

Identify the optimal capital budget allocation, or what proportion of the budget comes
from equity vs. debt financing

Determine the amount of equity needed to finance that capital budget for a
given capital structure.

Meet equity requirements to the maximum extent possible with retained earnings.

Pay dividends with the "residual" earnings that are available after the needs of the
optimal capital budget are supported. The residual dividend policy implies that
dividends are paid out of leftover earnings.

What is a 'Dividend'
A dividend is a distribution of a portion of a company's earnings, decided by the board of
directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares
of stock, or other property.
Next Up
1.

Dividend Policy

2.

Dividend Rate

3.

Forward Dividend Yield

4.

Cash Dividend

5.
BREAKING DOWN 'Dividend'
The dividend rate may be quoted in terms of the dollar amount each share receives (dividends
per share, or DPS), or It can also be quoted in terms of a percent of the current market price,
which is referred to as the dividend yield.
A company's net profits can be allocated to shareholders via a dividend, or kept within the
company as retained earnings. A company may also choose to use net profits to repurchase
their own shares in the open markets in a share buyback. Dividends and share buy-backs do
not change the fundamental value of a company's shares. Dividend payments must be
approved by the shareholders and may be structured as a one-time special dividend, or as an
ongoing cash flow to owners and investors.
Mutual fund and ETF shareholders are often entitled to receive accrued dividends as
well. Mutual funds pay out interest and dividend income received from their portfolio
holdings as dividends to fund shareholders. In addition, realized capital gains from the
portfolio's trading activities are generally paid out (capital gains distribution) as a year-end
dividend.
The dividend discount model, or Gordon growth model, relies on anticipated future dividend
streams to value shares.

Companies That Issue Dividends

Start-ups and other high-growth companies such as those in the technology or biotechnology
sectors rarely offer dividends because all of their profits are reinvested to help sustain higherthan-average growth and expansion. Larger, established companies tend to issue regular
dividends as they seek to maximize shareholder wealth in ways aside from supernormal
growth.
Companies in the following sectors and industries have among the highest historical dividend
yields: basic
materials, oil
and
gas, banks
and
financial, healthcare
and
pharmaceuticals, utilities, and REITS.
Arguments for Issuing Dividends
The bird-in-hand argument for dividend policy claims that investors are less certain of
receiving future growth and capital gains from the reinvested retained earnings than they
are of receiving current (and therefore certain) dividend payments. The main argument is that
investors place a higher value on a dollar of current dividends that they are certain to receive
than on a dollar of expected capital gains, even if they are theoretically equivalent.
In many countries, the income from dividends is treated at a more favorable tax rate than
ordinary income. Investors seeking tax-advantaged cash flows may look to dividend-paying
stocks in order to take advantage of potentially favorable taxation. The clientele
effect suggests especially those investors and owners in high marginal tax brackets will
choose dividend-paying stocks.
If a company has a long history of past dividend payments, reducing or eliminating the
dividend amount may signal to investors that the company could be in trouble. An
unexpected increase in the dividend rate might be a positive signal to the market.
Dividend Payout Policies
A company that issues dividends may choose the amount to pay out using a number of
methods.

Stable dividend policy: Even if corporate earnings are in flux, stable dividend
policy focuses on maintaining a steady dividend payout.

Target payout ratio: A stable dividend policy could target a long-run dividend-toearnings ratio. The goal is to pay a stated percentage of earnings, but the share payout
is given in a nominal dollar amount that adjusts to its target at the earnings baseline
changes.

Constant payout ratio: A company pays out a specific percentage of its earnings each
year as dividends, and the amount of those dividends therefore vary directly with
earnings.

Residual dividend model: Dividends are based on earnings less funds the firm retains
to finance the equity portion of its capital budget and any residual profits are then paid
out to shareholders.

Dividend Irrelevance
Economists Merton Miller and Franco Modigliani argued that a company's dividend policy is
irrelevant, and it has no effect on the price of a firm's stock or its cost of capital. Assume, for
example, that you are a stockholder of a firm and you don't like its dividend policy. If the
firm's cash dividend is too big, you can just take the excess cash received and use it to buy
more of the firm's stock. If the cash dividend you received was too small, you can just sell a
little bit of your existing stock in the firm to get the cash flow you want. In either case, the
combination of the value of your investment in the firm and your cash in hand will be exactly
the same. When they conclude that dividends are irrelevant, they mean that investors don't
care about the firm's dividend policy since they can create their own synthetically.
It should be noted that the dividend irrelevance theory holds only in a perfect world with no
taxes, no brokerage costs, and infinitely divisible shares.

What is a 'Dividend Policy'

A dividend policy is the policy a company uses to decide how much it will pay out to
shareholders in the form of dividends. Some research and economic logic suggests
that dividend policy may be irrelevant (in theory), but many investors rely on dividends as a
vital source of income.
BREAKING DOWN 'Dividend Policy'
Because dividends represent a form of income for investors, a company's dividend policy is
an important consideration for some investors. As such, it is an important consideration for
company leadership, especially because company leaders are often the largest shareholders
and have the most to gain from a generous dividend policy. Most companies view a dividend
policy as an integral part of the corporate strategy. Management must decide on the dividend
amount, timing and various other factors that influence dividend payments over time. There
are three types of dividend policies: a stable dividend policy, a constant dividend policy and a
residual dividend policy.
Stable Dividend Policy
The stable dividend policy is the easiest and most commonly used policy. The goal of the
policy is to aim for steady and predictable dividend payouts every year, which is what most
investors are seeking. When earnings are up, investors receive a dividend. When earnings are
down, investors receive a dividend. The goal is to align the dividend policy with the longterm growth of the company rather than with quarterly earnings volatility. This approach
allows the shareholder to have more certainty around the amount and timing of the dividend.

Constant Dividend Policy

The primary drawback of the stable dividend policy is that, in booming years, investors may
not see a dividend increase. By contrast, under the constant dividend policy, a percentage of
the company's earnings are paid every year. In this way, investors experience the full
volatility of company earnings. If earnings are up, investors get a larger dividend; if earnings
are down, investors may not receive a dividend. The primary drawback to the method is the
volatility of earnings and dividends. It is difficult to plan when dividend income is highly
volatile.
Residual Dividend Policy
A residual dividend policy is also highly volatile, but for some investors, it is the only
acceptable dividend policy that a company should have. In a residual dividend policy the
company pays out what's left after it pays for capital expenditures and working capital needs.
This approach is volatile, but it makes the most sense in terms of business operations.
Investors don't want to invest in a company that justifies its increased debt with the need to
pay dividends.

What is a 'Forward Dividend Yield'

A forward dividend yield is an estimation of a year's dividend expressed as a percentage of
current stock price. The year's projected dividend is measured by taking a stock's most recent
actual dividend payment and annualizing it. Forward dividend yield is calculated by dividing
a year's worth of future dividend payments by a stock's current share price.
BREAKING DOWN 'Forward Dividend Yield'
For example, if a company pays a Q1 dividend of 25 cents and you assume the company's
dividend will be consistent, then the firm will be expected to pay $1.00 in dividends over the
course of the year. If the stock price is $10, the forward dividend yield is 10%.
The opposite of a forward dividend yield is a trailing dividend yield, which shows a
company's actual dividend payments relative to its share price over the previous 12 months.
When future dividend payments are not predictable, trailing dividend yield can be a better
measure of value. When future dividend payments are predictable or have been announced,
forward dividend yield is a more accurate too

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