Fundamental Analysis · Intermediate · 4 min
Dividend yield and payout ratio
You can calculate dividend yield and payout ratio, check whether a dividend is covered by earnings and cash, and explain why a high yield can be a warning.
Is 8% better than 2%?
Dividend lists are popular: shares sorted by their dividend yield, the highest at the top. An 8% yield looks four times as attractive as 2%.
Often the opposite is true. A yield that looks unusually high can be a sign that investors no longer believe the dividend will last. Two simple ratios help you tell a generous dividend from a fragile one.
Paid out vs. kept
The dividend yield divides the dividends paid over the last year by the current share price. The fictional bicycle maker pays 0.20 per share. At a price of 10, its yield is 2%.
The payout ratio divides the dividend by earnings per share, or total dividends by net income. It shows how much of the profit goes to shareholders and how much stays in the company for investment, debt repayment or reserves.
The bicycle maker earns 0.50 per share and pays 0.20, a payout ratio of 40%.
Profit is only half the check. Dividends are paid in cash, so compare them with free cash flow too. The bicycle maker paid 20 million in dividends from free cash flow of 50 million, so the dividend is covered by both profit and cash.
Warning signs:
- a payout ratio above 100% for more than a year: the company pays more than it earns,
- dividends larger than free cash flow, paid with new debt,
- falling profits while the dividend stays the same.
None of these means a cut is certain, but each means the dividend depends on things improving.
Price down, yield up
What is normal depends on the business. According to Aswath Damodaran's data for US companies as of January 2026:
Software companies paid out about 21% of their profit, because they reinvest much of it. Tobacco companies paid out about 88%, because their business needs little new investment.
Now the trap. Suppose bad news halves the bicycle maker's share price from 10 to 5. Last year's dividend of 0.20 now gives a yield of 4%. Nothing about the dividend has improved. The yield rose only because the price fell, often because investors expect a cut. If the company does cut to 0.10, the yield at a price of 5 is back to 2%, and the shareholders have lost half their capital.
Common mistakes
- Sorting by yield alone. The highest yields often belong to companies in trouble.
- Treating the dividend as certain income. Boards decide on dividends and can cut or suspend them.
- Checking profit but not cash. A dividend paid from borrowed money cannot last.
- Forgetting that the price adjusts. On the ex-dividend date, the share price usually falls by about the dividend, so the payout is not free money.
The takeaway
Dividend yield compares the dividend with the price, the payout ratio with profit. A very high yield often means the market doubts the dividend.
Check yourself
Quick quiz
4 questions. Instant feedback, nothing is saved.
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1Tap the part of the profit that went to shareholders as dividends.
Tap the chart.
20 million of 50 million is a payout ratio of 40%. The other 60% stays in the company.
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2A share costs 40 and pays a dividend of 1.20 a year. What is the dividend yield?
Dividend yield = dividend ÷ price = 1.20 ÷ 40 = 3%.
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3A company earns 1.00 per share and pays 1.40 in dividends. What does that suggest?
A payout ratio of 140% means the company pays more than it earns. It can do that for a while from cash or debt, not forever.
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4A share's dividend yield jumps from 3% to 7% in a few months. What is the most likely cause?
The yield uses last year's dividend. When the price falls, the yield rises automatically, before any cut is announced.
of 4 correct.