Many investors buy stocks with the goal of not only selling their shares at a profit, but also collecting dividends, which are a portion of a company's earnings that are distributed to shareholders. But when a company pays a dividend, it may or may not be able to sustain that payout for the long haul. In fact, some companies intentionally pay out higher dividends than they can afford in an effort to keep investors happy and prevent their share prices from dropping.
That's why it's important to evaluate the sustainability of a company's dividend payments, which is what the cash dividend payout ratio is used for. The cash dividend payout ratio measures the proportion of cash flow a company pays to common-stock holders after subtracting preferred dividend payments. It shows what percentage of a company's net income is being paid in the form of cash dividends.
Calculating the cash dividend payout ratio
The cash dividend payout ratio is calculated by taking the amount of cash dividends paid to common shareholders and dividing it by a company's cash flows minus capital expenditures and preferred dividend payments. The following formula can be used to calculate the cash dividend payout ratio:
Cash dividend payout ratio = common stock dividends / (cash flow - capital expenditures - preferred dividends)
If a company pays its common shareholders $2 million in cash dividends, has $20 million in cash flow, has $8 million in capital expenditures, and pays preferred shareholders $4 million in dividends, then its cash dividend payout ratio would be 25%:
Cash dividend ratio = $2 million / ($20 million - $8 million - $4 million) = 0.25
Using the cash dividend payout ratio
The cash dividend payout ratio is a strong measure of a company's likelihood to sustain its current level of dividends. If a company's cash dividend payout ratio is high, then it's using a large percentage of its cash flow to pay common shareholders.
Companies with financial problems often pay investors higher dividends than they can afford so that their shareholders won't sell. If a company lowers its dividend payments because of cash flow problems, then investors might see it as a red flag and sell their shares, which could cause stock prices to plummet. Companies will therefore sometimes stretch themselves to keep up with higher payments in order to retain investors.
The cash dividend payout ratio can help investors determine just how sustainable those dividends are. If a company's cash dividend payout ratio is higher than 100%, it means that it's paying more in dividends than it's receiving in cash -- a practice that's unsustainable in the long run.
If you're thinking of buying a dividend-paying stock, then it's important to consider its cash dividend payout ratio. Many people who invest in dividend stocks count on those dividends to provide income. The cash dividend payout ratio can help you determine how long a company is likely to keep up with its dividends so that you can make an informed decision as an investor.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!