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Joseph P. Porter
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I am a retired college faculty in Philosophy, with specializations in Ethics, Socio-political Theory and Rational Choice/Decision Theory. My teaching focus was on Business Ethics, Medical Ethics and Logic. After retirement I freelanced as a Grant Writer/Fund Raising Consultant. I have taught at... More
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  • More On Earnings-Per-Share - Dividend Shortfall 0 comments
    Oct 16, 2012 3:13 PM

    Investment sites will occasionally refer to a "Payout Ratio," which is derived by dividing the dividend or the projected dividend for a year by the earnings per share a company has accrued. I find this figure misleading and counter intuitive. Consider the following examples:

    • Company A claims to pay $1.50 per share per year in dividends. They have, after 6 months, a total earnings/share of $.70. Following the calculation for payout ratio, we divide the projected dividend by the EPS (1.50/.70), which gives us a ratio of 2.14:1.
    • Company B pays $1.00 per share per year. B has, after 6 months, an EPS of $2.00. B's payout ratio is .5:1.

    What do these numbers mean? In A's case, the ratio says that for every $2.14 A pays out, it earns $1.00. This sounds odd, since (1) A doesn't pay out $2.14 - it pays out $1.50; (2) A doesn't have earnings of $1.00 per share, it has $.70.

    B's case is a little easier to comprehend. The payout ratio of .5:1 means that for every $.50 they pay out in dividends they have earnings of $1.00. A little better, and easier to understand, but still, it seems a bit awkward.

    To confuse things a bit more, the payout ratio is not always presented as a ratio, but as a percentage. In this case, A's payout ratio is 214.00%, and B's is 50.00%. Now, 214% of something looks quite nice. 50% of something looks a little less nice. However, B is in excellent shape while A is not close to being able to cover its dividend.

    Another way to look at it is: the lower a payout ratio, the better it is, and anything less than 100 is excellent (meaning that the company has more than enough earnings per share to cover its dividends).

    The British have a different way of doing things. Instead of a "payout ratio" they have a dividend cover. A company's dividend cover is determined by dividing the earnings per share by the dividend - that is, the dividend cover is the inverse of the payout ratio. To see the difference, let's run our two examples again:

    • Company A claims to pay $1.50 per share per year in dividends. They have, after 6 months, a total earnings/share of $.70. To determine the dividend cover, we divide the earnings per share by the projected dividend. The result is: .70/1.50 = .47, or 47%.
    • Company B pays $1.00 per share per year. B has, after 6 months, an EPS of $2.00. Their dividend cover is 2.00/1.00 = 2.00, or 200%.

    What do the numbers tell us? For A, the dividend cover tells us that A only has 47% of its dividend covered by EPS. Straightforwardly, we know that A cannot yet cover its full dividend, and must make up the remaining 53%.

    B, on the other hand, has a dividend cover of 200%, or double the EPS it needs to cover its dividends.

    Very straightforward.

    What's the purpose to this? I propose, in the future, to refer to "dividend cover" rather than to "payout ratio," as a way of informing the (potential) investor how close (or how far) a company is from covering its dividend with EPS.

    That, a cuppa and a scone will do just fine. Bob's yer uncle (whatever that's supposed to mean).

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