The dividend payout proportion is a popular tool used to make an evaluation of the safety of a firm’s dividend payments. This ratio is used to measure the proportion of a company’s net earnings that’s paid out to investors as dividends. The theory sounds simple, but as you will see, there are a few issues to think about once you have calculated this value.

The dividend payout ratio is calculated by dividing the dividend per share by the net income per share, and is generally then multiplied by 100 and represented as a %. A very important detail to remember is to be certain the values you use in this calculation cover the same time period. An example will help illustrate this:

In 2010, Abbott Laboratories (ABT) reported $2.99 in net earnings per share, and $1.76 in dividends paid per share. In this example, Abbott Laboratories had a dividend payout ratio = ($1.76/$2.99) *100% = 59%. Since Abbott Labs paid 59% of their net income to investors in the shape of cash dividends, that also means they kept 41% of their profits to help them grow their business.

So now you know how to work out the dividend payout proportion, how do you use it to ascertain whether a stated level is bad for the high dividend stocks you are assessing? Well, that all depends upon the company you are gauging, the industry it is in, and several other variables.

Let’s begin with an obvious case, where the dividend payout proportion is larger than 100%. Yes, there really are stocks out there right now with dividend payout ratios of 100% or more. Clearly this is not a long term viable condition. These firms are paying their dividends by drawing down their money, selling assets, selling more stock (and dilluting the value of shares held by current shareholders), or even taking on debt. Sometimes this is a very temporary condition, when a company has fallen on difficult times, or has experienced a single bad event, like losing a suit. Other times, it is a continuing issue that will eventually resolve itself by cutting the dividend. Obviously, it is better for a company to have a dividend payout ratio below 100%.

To have a look at the opposite end of the range, firms with excessively low dividend payout proportions are more likely to have a safe dividend, since they’ve got a bigger percentage of their profits available from which to maintain the prevailing dividend payment levels. Also, if there’s a low payout proportion, there’s room to grow the dividend in the future.

For the great majority of dividend paying stocks, the dividend payout ratio is significantly below 100%. It’s best to review the percentage of the company you are thinking about buying against its historical ratio for the last few years. If the dividend payout proportion is steadily increasing, you need to do a little homework to figure out why.

You need to also compare the dividend payout ratio of the stock you are checking out alongside other stocks that pay dividends in the same industry. Different industries have different average payout proportions. For instance, regulated power corporations have often high dividend payout proportions, since their profits are comparatively stable. If your company is too far below or above the average dividend payout proportion for the industry it is in, you should investigate why.

Lee Franzen has a passion for finding high dividend stocks with safe dividends. The dividend payout ratio is one of many tools that can be used to find good dividend stocks.