“The proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage.”
It’s maybe helpful to think of it as similar to finances on a personal level. You have some money coming in each month and you can either spend or save it. Maybe you spend 50% of it on housing, food, entertainment, etc. You spend 20% of it on things that will improve your future: home repairs or education. Then, you save 30% of it for a rainy day or use that to pay down your debts.
It’s similar in a company. Out of all their earnings, maybe the company spends 30% to pay rent/salaries, etc. They spend 30% paying out dividends to shareholders and they spend 60% investing in the future of their company. So their payout ratio would be 30%.
If a person is spending more than what they have coming in, they’re using credit cards or lines of credit or some other such terrible thing. If a company has a payout ratio or more than 100%, it’s a huge warning sign. They’re borrowing money to pay the dividend or they’re issuing more shares, which will eventually force the stock price down (supply/demand). They’re certainly not paying down debt, saving for a rainy day, or investing in the future of their company.
When I look at stocks, a payout ratio of around 30-40% is ideal. This means that they’re serious about giving shareholders value in terms of the dividends that they pay. But, 10-20% might not be terrible if it a high growth company that is making significant investments for future growth. It just depends. Conversely, anything around 50-60% is kind of a danger sign and I will probably not invest in that company. 70% or higher: never! No matter how high the dividend is and how appealing it looks.
Check out the bible of value investing from one of the greats for more details: