Understanding the Payout Ratio
The payout ratio is the share of a company's earnings paid out as dividends. It is the single best quick gauge of whether a dividend can be sustained.
How it is calculated
Divide the annual dividend per share by earnings per share. A payout ratio of 0.40, or 40 percent, means the company returns forty cents of every dollar earned and retains the rest to reinvest, pay down debt, or build a cushion.
A more conservative version divides the dividend by free cash flow instead of earnings, since cash flow is harder to massage than reported earnings and is what actually funds the payment.
Reading the number
A moderate ratio leaves room to keep paying through a weak year. A ratio approaching or exceeding one means the dividend is consuming all or more than all of earnings, which is difficult to sustain without cutting the payout or raising cash elsewhere.
Context matters: REITs are required to distribute most of their income and so run high ratios by design, while a fast grower may deliberately keep its ratio low to fund expansion. Compare a company to its own history and its sector, not to a single universal threshold.