A constant dividend payout ratio policy is a dividend policy in which the percentage of earnings paid in the form of dividends is held constant. In other words, a constant dividend payout ratio policy maintains the same proportion of earnings paid out as dividends to shareholders.
Dividend Payout Ratio Formula
The dividend payout ratio is as follows:
Dividends Paid is the dollar amount of dividends distributed to shareholders;
Dividend Payout Ratio = Dividends per Share / Earnings per Share
Example of a Constant Dividend Payout Ratio Policy
Colin is an analyst looking to determine the future dollar dividend payouts of Company A. The company follows a constant dividend payout ratio policy of 25%. Through the estimated forward earnings per share for fiscal 2020, 2021, and 2022 below, determine the expected dollar dividend payout per share.
With a constant payout ratio policy of 25%, a quarter of the company’s forward earnings per share will be distributed as dividends to shareholders. The dollar expected dividend payout per share is as follows:
The expected dollar dividend payout through the fiscal years 2020-2022 is $0.375 + $0.575 + $0.675 = $1.625.
Implications of a Constant Dividend Payout Ratio Policy
With a constant dividend payout ratio policy, the amount of dividends paid to shareholders fluctuates directly in proportion to the earnings of a company. Therefore, such a dividend policy comes with the potential to generate very volatile dividend payouts.
The dividend payout policy also offers companies more flexibility as they do not need to alter the payout(s) during deteriorating market conditions (since the payout is a proportion of earnings and not a dollar amount), which typically sends a negative signal to market participants.
There are several things that a company should keep in mind when setting a constant dividend payout ratio policy. They include:
1. Current business life cycle
Companies that operate in the launch, growth, and shake-out stage of the business life cycle tend to offer a lower payout ratio compared to more mature and established firms. In the early stages of a company, it will tend to choose to follow a low payout ratio policy so that it can reinvest its earnings back into the business.
2. Industry outlook
Setting a constant dividend payout ratio requires forward thinking – pullbacks to a company’s dividend policy result in an adverse effect and signals a weakening company. A company must consider its future prospects and its earning potential before setting a constant dividend rate.