Whatever.com has earnings. Big earnings. A hundred million dollars worth of earnings this year from sales of a whole lotta whatevers.
The board green lights a dividend payment of 40 million bucks. That is, the company will pay 10 million dollars to its common shareholders of record 4 times in this next year. The payout is 40 million because it’s, uh… paid out. And yeah, clever titling was never a Thing on Wall Street. The payout ratio is 40 over 100...or 40 percent.
So why does the payout ratio even matter? Well, companies hate having to cut their dividends…and they love raising them. In the former, stock prices usually crash; in the latter, they usually go up. And companies love it when their stock prices go up. Duh.
So what would happen if Whatever.com stumbled, and its earnings tumbled, and then shareholders mumbled that the earnings payout ratio had, uh… crumbled? That is…what if the earnings of whatever.com went down next year to only 50 million?
Hm. Problem. Because now the payout ratio is 80 percent (40 over 50). Very difficult situation. The company thought it would have tons of earnings to cover its dividend at the 40 million level more or less forever. But clearly it did not.
So now what?
Well…if earnings recover and go back to 100 million on their way to 300 million, then life is grand. No sweat. No heavy decisions to be made. But what if earnings fall further to be only 30 million the following year? Well, then whatever.com has to either borrow money or deplete its cash to cover or pay its dividend...in which case the payout ratio would potentially be over 100%, meaning that if earnings were 30 mil and the dividend was to 40 mil, then the payout ratio would be 40 over 30, or 133%. Ouch. Can’t do that for very long without going bankrupt.
So payout ratios matter...because they give a sense for how certain that dividend is to continue.
If the ratio is low, odds are good the company could certainly afford to raise the dividend, or at least not cut it…for a long time. If the ratio is high, your bottom line may soon be, uh…bottoming out.
Related or Semi-related Video
Finance: What is an Accumulated Dividend...9 Views
finance a la shmoop what is an accumulated dividend okay you know what
a dividend is companies generally commit to paying it when they have so much [Example of dividend meaning on a 100 dollar bill]
extra cash profit that they really don't know what to do with the dough yeah nice
place to be in the case of a preferred stock the dividends aren't just a
optional-ish they operate more like bond interest only with a catch
that is dividends on preferred stock can in fact be halted without the company
being repossessed by the debt holders like in the case where the company falls [Prize wheel lands on hard times]
on hard times or it wants to preserve its cash to buy a competitor or it just
wants another jet with a water slide thing on it well yeah it can halt its [Person slides down a jet slide]
dividend in those cases and well there are two types of preferred stock in this
realm the ones that pay cumulative dividends and the ones that don't
cleverly named non-cumulative say a company has halted dividends from its
preferred for three and a half years and it was paying five bucks a quarter in [Dividend distribution graph]
dividends from those cumulative preferred well if it was to resume
paying dividends on them it would first have to pay all back fourteen quarters
worth of dividends before it began to issue more dividends or pay them to its
preferred holders that is it owed three years times four quarters or twelve
quarters plus half a year or two quarters for a total of fourteen
quarters at five bucks a quarter a share that's five times fourteen or seventy [Formula of non-cumulative dividends]
dollars a share in back cumulative dividends big obligation but it has to
pay that amount before it can resume dividend payments why would a company
have a cumulative feature in its preferred dividend obligation well
because investors forced it to do so or they wouldn't invest they were worried [Person swipes away stacks of money]
that the preferred dividends might be just some merrily stopped and then the
investors would have little or no return on their investment in the preferred and
this can be a problem for companies that have fallen on hard times they are
essentially made illiquid in that they can't afford to pay the back dividends [Example of illiquid meaning]
on the preferreds and they can't raise more capital with this blight on their
record of having stopped paying a divvy well most [Non cumulative stock stickers appear on a table]
furred stocks are non-cumulative and if companies decide to just stop paying
them they can but if they do it's kind of like they've reneged on a handshake [Two guys giving a handshake]
and you know investors talk so like good luck to the company ever trying to raise
capital again from the cold cruel outside world yeah welcome to Wall
Street [Wall Street road sign]
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