Cash-minded investors love their dividend payouts.

In fact, dividends have played a substantial role in the returns investors have garnered during the past 50 years. According to a study from the Hartford Funds and Morningstar(MORN) - Get Report dating back to 1960, 82% of the total return of the S&P 500 Index can be attributed to reinvested dividends and the power of compounding.

What Main Street investors may not know is the significant role that payout ratios play in the stock dividend investment world.

What Is a Payout Ratio?

Payout ratios, otherwise known as dividend payout ratios, are defined as the percentage of net income that a publicly-traded company shells out as part of their dividend payments to investors. In real-speak, payout ratios have limited use in measuring a company’s full financial picture, but they do go a long way in describing how a company views its shareholders – good or bad.

Basically, payout ratios can be viewed in two ways:

  • They can demonstrate the percentage of earnings paid out to shareholders in dividend payouts, usually shown as the percentage of a firm’s financial earnings.
  • Or, a company’s payout ratio can also be expressed as dividends paid out as a proportion of cash flow

The Link Between Payout Ratios and Dividend Payouts

Financially, payout ratios aren’t all that complicated.

For example, for a payout ratio of 5% for every dollar paid out in net income, that same amount is paid out in dividends. In the real world, let’s say that Pfizer (PFE) - Get Report (one of the market’s best dividend stocks) earns $100 million in net income and the company’s payout ratio is 25%. In that scenario, the company pays out $25 million in dividends to shareholders.

Investors would do well to pay close attention to payout ratios, as they provide a glimpse into that company’s financial health.

Let’s say a company has a high payout ratio. That could mean the firm is focused on appeasing shareholders with higher dividend payouts, and keep them from selling shares. Bigger companies with a steady long-term earnings view are more likely to offer higher dividend payments to shareholders, and have larger payout ratios.

If a company has a lower payout ratio, it could mean that company is holding its financial cards closer to its vest, and is likely using its net income not to satisfy shareholders but to reinvest the cash to pave the way for stronger financial growth over the long haul.

A Word on Dividend Payments

Dividends are a company’s way of saying “thanks” to its shareholders.

For each share of stock the investor owns, that investor is rewarded with a portion of that company’s earnings. In other words, the investor is paid just for owning the company’s stock.

While dates can vary, most companies pay out dividends on a quarterly basis. Those payments are preceded by three key dates:

The Declaration Date

This is the date that a company’s board of directors announces the company announces its intention to pay out a dividend.

The Date of Record

 This date signifies who will receive the company dividend payout. Specifically, the date or record shows the “holders of record” on the date of record, meaning they are qualified to receive a dividend payout.

The Ex-Dividend Date

This date marks the exact date that a shareholder must be a holder of record. Shares of stock must be purchased before the ex-dividend date in order for the shareholder to receive a dividend payout.

Here’s an example:

Company A pays a dividend of 20 cents per share. With four payment dates per year, the company pays out 25% of 20 cents, which translates into 5 cents per share. The more shares you own, the higher the payment.

Eligible shareholders don’t have to cash in on their dividend payments. Instead, they can reinvest their dividend payouts, which gives you a higher amount of stocks held in the company.

What Is the Payout Ratio Formula?

Here’s the formula financial specialists use to calculate payout ratios, which determines the dividend payouts companies make to their shareholders.

  • Payout Ratio = (Total Dividends Paid)/(Net Income/Earnings)
  • Payout Ratio = (Total Dividends (Common and Preferred) per Share)/(Earnings per Share)

Basically, the payout ratio is configured as the percentage of earnings paid out to shareholders as dividends.

For instance, if a firm generates $1 per share on a quarterly basis, and paid out a dividend of 50 cents per share, that company’s payout rate would stand at 50%.

Is that figure a good indication of a healthy dividend payout structure? It depends. Just because a company keeps dividend payout ratios low doesn’t mean it’s a skinflint towards its shareholders. It could be keeping money on hand to better reinvest assets and grow the company. The same company may also plan on providing dividends down the road – it just wants to build the financial health of the company first, by investing as much internal cash as possible in the company now.

Companies that pay out more robust dividends may be bumping up against maximum growth – it could a major leader in a big industry. For firms of that size and scope, a stronger dividend and a more favorable outlook on its shareholders is just good business.

Regular and Reliable Payout Ratios

Managing the proper amount of dividend payments means establishing a target for company payout ratios, and then using those ratios as a reliable, long-term calculus for figuring out what companies can pay in dividends over the long haul. The goal is to establish a regular record of making four dividend payments annually over a period of years, preferably with no break or gaps in making dividend payments.

That’s where payout ratios can really help a company establish a regular and reliable pattern of dividend payments to shareholders.

But to have a record of regular dividend payments means a company must also have a regular pattern of stable and accurate payout ratios – and the most successful dividend companies do exactly that.