What is a Payout Ratio in plain words?

Look at the Payout Ratio Before the Yield
Judging a stock simply by its dividend yield is the worst thing an investor can do. There are many factors that can affect a stock and just because a stock has a high yield means nothing. One significant factor that can affect the dividend yield is the payout ratio.

What it stands for
The payout ratio is calculated as follows: Dividends / Net Income
Therefore, if a stock has an 80% payout ratio, which means it is paying out 80% of its earnings. This shouldn’t necessarily set a red light off, it just depends on what kind of company that you are trying to invest in.

Why the Payout Ratio is Important
Companies that don’t need too much capital to operate can afford to pay out a significant portion of their income. However, if a growth company has an 80% payout ratio they’re creating their own grave by limiting the capital that they can “grow” on. The company should never be paying close to a 100% of their profits for obvious reasons.

Some companies however do have a payout ratio over 100%. This means that either their earnings have decreased or their expenses have gone up. Either way, this will most likely lead to a dividend cut, otherwise it would mean that the company is losing money just because they are paying out insane dividends for their stock.

How to use the Payout Ratio
Although you shouldn’t be basing your investment solely on the payout ratio, it never hurts to see what the payout ratio is to determine if you should buy the stocks. Blue-chip stocks may have a higher payout ratio because they don’t need too much to operate.

Mo2 Thinks
Always think of what kind of company you are trying to invest in and how well the industry is doing. Remember all sorts of factors are linked and the better grasp you have of the overall picture, the better your investment decisions. The payout ratio is important however it should never determine if you are going to invest in a stock. If I were to buy a stock the payout ratio would definitely be a key factor to look at, if the stock has a dividend, because it shows if the company is smart enough to keep the ratio under control.

Always be careful of extremely high payout ratios. Unless you know it’s a stable company then this should set off a red light in your head. An extremely low payout ratio can also mean that the company may be due for a dividend increase. Never know, but if it’s a sound company there may be a decent chance of that. Anyhow, happy investing!

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