Target Payout Ratio

A target payout ratio is a measure of the percentage of a company's earnings it would like to pay out to shareholders as dividends over the long-term. Firms are conservative in setting their target dividend payout ratio with the goal of being able to maintain a stable dividend level tied to the company’s long-run, sustainable earnings.

Target payout ratio is expressed as (dividends per share / earnings per share)

Since dividend cuts are perceived negatively by markets, management teams are usually reluctant to increase dividends unless they can be fairly confident they will not have to reverse their decision due to cash flow pressure in the near future.

Firms strive for a stable dividend level that aligns their stock’s dividend growth rate with the company's long-term earnings growth to provide a steady dividend over time. A company with a stable dividend policy can choose to use a target payout ratio adjustment model to gradually move toward its target payout as its earnings rise.

Expected dividend = (previous dividend) + [(expected increase in EPS) x (target payout ratio) x (adjustment factor)]

where: adjustment factor = (1 / # of years over which the adjustment in dividends will take place)

A company with a residual dividend model, where its stock dividends are based on the amount of residual earnings left over after the company has paid all its expenses and other obligations, can also use a target payout ratio.

The following steps can be followed to determine the target payout ratio:

1. Identify the optimal capital budget allocation; in other words, the proportion of the budget that is financed with equity versus debt financed.
2. Determine the amount of equity needed to finance that capital budget for a given capital structure.
3. Meet equity requirements to the maximum extent possible with retained earnings.
4. Pay shareholder dividends using the "residual" earnings that are available after the needs of the optimal capital budget are supported. This residual dividend policy implies that dividends are paid out of leftover, residual, earnings.

Investors closely follow information related to dividend payout, and stock prices often react poorly to unexpected changes in a company’s target payout ratio. Because of the message that dividend policy can send about a company’s prospects, company managements share payout guidance as well as planned changes to target payout ratios. Stock analysts particularly want to understand a company’s dividend policy and payout strategy as well as how it compares to the industry level.