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Looking for sustainable dividends? Check out the dividend pay-out ratio…

by , 03 December 2014

If you're investing for income, dividends play a vital role in your strategy.

Whilst there are no guarantees that a company will always pay out a dividend, you can check the likelihood of this with some simple calculations.

One of these calculations is the dividend pay-out ratio.

So how can you calculate the dividend pay-out ratio? And how can you use this information?

Read on to find out…

What is the dividend pay-out ratio?

To calculate the dividend pay-out ratio, you need to work out the dividend cover first.

You can do this by:

Dividend cover = Earnings per share (EPS)/dividend per share (DPS)

Let’s say a company’s EPS was R30 and its pays a dividend of R10, its dividend cover is three. In other words, the company can pay its dividend three times using its profits.

To calculate the dividend pay-out ratio, you just divide one by the dividend cover…

Dividend pay-out ratio = 1/dividend cover

Going back to our example, this would give a dividend pay-out ratio of 33% (1/3).

How to use the dividend pay-out ratio

Companies that have lower dividend pay-out ratios tend to have safer dividends. This is because they have more scope to increase them by paying out of a larger share of their profits.

But using EPS to calculate the dividend pay-out ratio can have its downfalls. This is because EPS isn’t always a very accurate figure to use.

If you find a company that looks good using EPS, investigate further using its free cash flow. You’ll find this on a company’s cash flow statement.

Instead of performing the above calculations using EPS, use free cash flow per share instead. If the ratio still looks good, you could be looking at a great dividend paying company.

So there you have it. Why you should use the dividend pay-out ratio if you’re looking for sustainable dividends.

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Looking for sustainable dividends? Check out the dividend pay-out ratio…
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