You know what a company's payout ratio is, right? It's the percentage of net income a company pays out to shareholders as a dividend. For example, Pfizer (NYSE:PFE) is expected to earn approximately $2 per share this year, and its annual dividend amount is currently $0.96. Divide $0.96 by $2.00 and you'll get 0.48, or a payout ratio of 48%. (Pfizer's recent dividend yield was around 3.8%.)

Is that good? Well, there is no exact, perfect payout ratio. But when the number is low, the firm is keeping most of its earnings for other uses, such as reinvesting in the business or buying back shares. Think of Microsoft (NASDAQ:MSFT) and its 28% payout ratio as an example. When the number is high, the company is returning much of its earnings to shareholders with little left over for other purposes. If you're an investor seeking dividend income, that can be a good thing. It's not always good, though.

Consider pharmaceutical firm Bristol Myers-Squibb (NYSE:BMY). With an annual dividend of $1.12 and earnings for 2006 expected to be around $1.19 per share, the payout ratio is a rather uncomfortable 94%. (The dividend yield is approximately 4.4%.) There's little room for error here, and as our Motley Fool Income Investor newsletter analyst Mathew Emmert has noted: "The company has avoided a dividend cut thus far, but I continue to believe its payout is in peril. If the company loses the patent challenge on its blood-thinning medication Plavix, I think a cut is assured. Even if it receives favorable news on this front, the payout ratio will remain high."

For comparison in the pharmaceutical industry, Merck (NYSE:MRK) sports a payout ratio of 65%, while Eli Lilly's (NYSE:LLY) is around 51%.

Beware of high numbers
There are many lessons to learn about dividends, and Mathew tackles them regularly in Income Investor. The examples above also offer a few. For starters, don't fall for the fattest dividend yield you can find. Since the yield is calculated by dividing the annual dividend by the current stock price, if the stock price falls, the yield rises. So a company in trouble may have a hefty yield -- at least until it reduces or eliminates its dividend.

Similarly, a high payout ratio is cause for concern. For example, Citizens Communications' (NYSE:CZN) current annual dividend is $1.00, and its recent price is around $13.32, giving it a quite attractive dividend yield of 7.5%. (Divide $1.00 by $13.32 and you'll get 0.075.) But its earnings per share for the past year are $0.60, up from $0.23 the year before. Do you see a problem here? How is this company expecting to pay out a dollar when it's taking in so much less? This isn't always an issue for a company, as it might rely on cash reserves, and its modest cash intake might be due to passing problems. But this is at least a red flag worth investigating. (Actually, Mathew did investigate this telecommunications firm, recommending it (with some caveats) back in September of 2004. It has since gained nearly 10%, and investors have also enjoyed a 7% to 8% dividend yield along the way.)

Find the best bets
So choose your dividend-paying investments carefully, my friend. And if you'd like some help zeroing in on healthy, growing companies that pay significant dividends, give our Income Investor newsletter a whirl. You can try it for free for a whole month, with access to all past issues, special reports, and Mathew's complete list of recommendations. In two and a half years, Mathew's picks have averaged a return of 18%, vs. 14% for the same amounts invested in the S&P 500. Fully 18 of them sport current dividend yields above 5%, and ten top 7%.

Here's to a hefty income in your future!

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Selena Maranjian owns shares of Microsoft and Pfizer. For more about Selena, view her bioandher profile. Merck, Eli Lilly, and Citizens Communications are all Income Investor recommendations. Microsoft and Pfizer are Inside Value picks. The Motley Fool isFools writing for Fools.