The dividend payout ratio is a popular tool used to evaluate the safety of a company’s dividend pay outs. This proportion is used to measure the share of a corporation’s net income that’s paid to shareholders as dividends. The theory sounds easy, but as you will see, there are a few issues to think about after you’ve figured out this value.

The dividend payout ratio is worked out by dividing the dividend per share by the net earnings per share, and is usually then multiplied by 100 and represented as a percentage. A crucial detail to keep in mind is to make sure the values you use in this calculation cover the same 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 profits to investors in the shape of cash dividends, that also suggests they kept 41% of their profits to help them grow their business.

So now that you understand how to work out the dividend payout proportion, how does one use it to figure out whether a stated level is good for the high dividend stocks you are evaluating? Well, that all relies on the company you are judging, the industry it is in, and a number of other variables.

Let’s start with an easy case, where the dividend payout proportion is bigger than 100%. Yes, there truly are stocks out there right now with dividend payout ratios of 100% or more. Obviously this is not a long-term viable condition. These companies are paying their dividends by drawing down their cash, selling assets, selling more stock (and dilluting the value of shares held by current investors), or perhaps taking on debt. Occasionally this is a very transient condition, when a company has fallen on difficult times, or has experienced a single bad event, like losing a court action. Other times, it’s a continuing issue that may eventually resolve itself by cutting the dividend. Clearly, it is better for a company to have a dividend payout proportion below 100%.

To have a look at the opposite end of the range, corporations with very low dividend payout ratios are much more likely to have a safe dividend, since they’ve got a larger percentage of their profits available from which to maintain the present dividend payment levels. Also, if there is a low payout ratio, there is room to grow the dividend in the future.

For the vast majority of dividend paying stocks, the dividend payout proportion is well below 100%. It’s best to check the percentage of the company you are considering purchasing against its historic ratio for the last few years. If the dividend payout proportion is steadily increasing, you must do a little homework to work out why.

You should also compare the dividend payout ratio of the stock you are checking out alongside other stocks that provide dividends in the same industry. Different industries have different average payout proportions. For instance, regulated utility companies have generally high dividend payout proportions, since their profits are relatively stable. If your company is too far above or below the average dividend payout ratio for the industry it is in, you should research 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.