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How to Calculate the Dividend Payout Ratio

The dividend payout ratio is a way to measure cash flows generated by a company to determine if current cash flow levels are sufficient enough to assure a continued stream of dividend payments to shareholders. When you buy a stock that pays an 8% dividend yield, you want to make sure the company will be able to keep paying this 8% yield for many years in to the future. The last thing you want to do is buy a stock for its relatively high dividend yield, only to be cut by the company because it was not sustainable in the first place. The formula for calculating dividend payout ratio is:

The above formula presented is popular among accountants as it includes lots of variables such as non-cash expenses e.g. amortization expense, depreciation, capital loss/writeoffs, asset impairments, etc. For finance junkies, here's a better way to calculate the dividend payout ratio:

You can easily find a company's dividend per share and earnings per share from Google finance, thus making it easy to calculate the dividend payout ratio. For instance, if a company pays out $0.50 per share in dividend payments annually and earns an EPS of $2 / share, the dividend payout ratio would be:

The question investors must ask themselves is, is this payout ratio good or bad? For companies that are growing fast, they will retain more cash to use for expansion projects thus have less money to pay out on dividends. Other companies that have already grown in their industry examples Microsoft (MSFT), Coca Cola (Coke), Johnson & Johnson (JNJ) will pay larger dividends because of little growth left in their industry. Another good example of such companies includes utilities companies such as Execelon Energy (EXC) that has a 5.47% yield as of the close on June 25, 2010.

Unsustainable Dividend?

Let's analyze the stock of World Wrestling Corporation (WWE). I've been a fan of wrestling entertainment for many years and would love to invest in this company. However, the dividend seems unsustainable to me. Why? Let's analyze:

- The company pays 36 cents a share quarterly, with annual dividends totaling $1.44/share.

- The company's earnings per share, as calculated using net income from the latest quarter is $0.87/share.

What is the dividend payout ratio in this scenario?

This tells us the company is paying dividends up to 166% of its earnings, meaning for every $1 the company earns, it pays out $1.66 in dividends. Can anyone tell me how this could be sustainable in to the future? I say this because the company only has total cash reserves of $149.78 million in cash & $58.44 million in short term investments totaling $208.22 million.

Sustainable Dividend?

Now let's analyze the stock of Johnson & Johnson (JNJ) which is featured in our list of aristocrats dividend paying stocks. Johnson & Johnson pays $0.54/share in dividends quarterly and has an earnings per share of $4.76. What is the dividend payout ratio for this company?

This signals to us that for every $1 the company earns, it pays $45.4 cents in dividend payments, leaving $0.546 for paying its workers' salaries, capital expenditures, research & development, acquisitions and other value added activities.