When investors buy stocks, they can make money two different ways. The first is by selling their shares for a price that's higher than their original cost. The second is by collecting dividends, which are a portion of a company's earnings distributed to shareholders. Not all stocks pay dividends, but those that do offer shareholders a steady stream of income. But just because a company is paying a certain amount in dividends at one point in time doesn't mean it will continue to uphold that practice. That's why it's important for investors to look at a company's payout ratio.

G

IMAGE source: AUTHOR.

The payout ratio is a way to measure the sustainability of a company's dividend payment stream. A lower payout ratio indicates that a company is retaining more of its earnings to fuel its growth, whereas a higher payout ratio indicates that a company is sharing more of its earnings with stockholders. A payout ratio of more than 100% means that a company's dividend payments are exceeding its net income.

Calculating the payout ratio

The payout ratio is used to determine whether a company's earnings are such that they can sustain its dividend payments. The payout ratio is usually expressed as a percentage and is calculated as follows:

Payout ratio = dividends per share (DPS) / earnings per share (EPS)

Let's say a company has earnings per share of $3 and dividends per share of $1. Its payout ratio would be 33%.

What the payout ratio tells investors

Those who buy stocks with the goal of collecting dividends want to make sure those payments are likely to continue or increase. The payout ratio can help investors determine whether the dividends a company is paying can be maintained in the long run.

Older, established companies will often have higher payout ratios since they have the capacity to share more of their earnings with stockholders. Newer companies, by contrast, will often have lower payout ratios because they need to retain more of their earnings to reinvest in and grow their businesses. Many investors prefer companies with lower payout ratios because they can continue to pay their current dividends even if they see a drop in earnings. Furthermore, companies with lower payout ratios have the potential to increase their dividend payments over time.

Either way, if a company's dividend payout ratio is over 100%, it means that it's paying out more money to investors than it's taking in. This isn't a sustainable model, and should be taken as a sign that dividend payments will likely go down in the future. Companies with the strongest long-term dividend payment records tend to have stable payout ratios over time.

If you're planning to buy a dividend stock and rely on that income, then it makes sense to look at its payout ratio to determine how much of a risk you're taking on. Keep in mind, however, that the payout ratio is just one method of evaluating a stock. There are numerous tools and formulas you can use to figure out whether your investment is a smart one. 

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 knowledgecenter@fool.com. Thanks -- and Fool on!

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.