In investing terms, a payout ratio is the percentage of a company's income that's paid out to shareholders as dividends. If a company earned $10 million in a quarter and paid out $4 million, it would have a 40% payout ratio.
Payout ratios are based on the dividends paid out to common stockholders. Any dividends paid to preferred stockholders aren't included in the payout ratio calculation. They're accounted for differently on a company's income statement.
Specifically, preferred stock dividends are already subtracted from the company's net income before per-share earnings are calculated.
Calculating the payout ratio
The general formula for payout ratio is quite simple. Take the company's dividends per share, divide them by earnings per share, and multiply the result by 100 to convert it to a percentage.
You can use any time period to calculate a payout ratio. You could calculate a company's payout ratio for a particular quarter, for example.
However, most payout ratio calculations use annual numbers. Using the last four quarters of dividends and earnings is a common calculation method.
Alternatively, if a company recently raised its dividend or if future earnings are expected to be significantly different, using the projected current-year numbers or the next four quarters of expected dividends and earnings could be the best choice.
Here's a real-world example. Take a look at Apple's (NASDAQ: AAPL) earnings and dividends for the past four quarters:
In this case, you'd divide the $3.04 in dividends by the $11.85 in earnings and multiply by 100. This shows that Apple's payout ratio over the past four quarters has been approximately 26%.
REITs are a special case
There's a special consideration when it comes to computing payout ratios for real estate investment trusts, or REITs.
In a nutshell, the traditional methods of calculating earnings don't translate well to companies with lots of real estate assets. Without getting too deep into the details, real estate earnings contain an accounting item known as depreciation. This shows up as a huge "expense" on a REIT's earnings report, although it doesn't actually cost anything.
For this reason, REIT earnings are best expressed by a metric known as funds from operations, or FFO. This adds depreciation back in and makes a few other adjustments to better reflect how profitable these businesses actually are. Many REITs also report company-specific versions of FFO, such as core FFO or adjusted FFO.
Here's the point: When calculating the payout ratio for a REIT, use per-share FFO, not per-share earnings, in the calculation.
How to use the payout ratio in your analysis
The payout ratio is most useful for evaluating the sustainability of a stock's dividend. A payout ratio above 100% means a company is paying out more than it's earning. That could indicate an imminent dividend reduction.
There's no specific cutoff when it comes to what payout ratio is too high. For most stocks, I like to see payout ratios of 50% or lower, but this can be flexible, depending on the situation. In the case of REITs, which are required to pay out most of their income, an FFO payout ratio in the 70% to 90% range is quite common, but any closer to 100% could be a cause for concern.
Finally, remember that payout ratio is just one piece of stock analysis. Just because a company has an acceptable payout ratio doesn't mean it's in good financial shape. Look at the entire picture of a company's financial condition and valuation before making an investment decision.