Understanding finance

DIVIDEND PAY-OUT RATIO

James Godrich, Research Assistant

I once overheard a conversation where one shareholder said to another, “When dividends hit my account I get a real buzz – that’s why I own the shares I do.”

Whilst an increase in dividends per share tends to be viewed as a positive by investors, it must be considered in proportion to earnings per share. This is an equation known as the dividend pay-out ratio, or one minus the earnings retention rate. 

Theoretically speaking, a nominally high dividend yield and a high earnings retention rate are not mutually exclusive and in fact hold an interesting relationship. That relationship states that the growth rate in dividends is equal to the return on equity multiplied by the earnings retention rate. Or put another way, the future growth in your dividends is dependent upon the fraction of earnings that are reinvested into the business and the return that those earnings produce in their subsequent use. 

This same theory can be used to explain the decision by more mature companies to pay larger dividends which represent a greater proportion of earnings. That’s because any retained earnings will be subject to diminishing returns on their reinvestment. As such, management may see less opportunity of reinvestment at a high return on equity. By the same token, a less mature company may see numerous high return on equity investments and wish to retain earnings in the hope of creating significant growth in future dividends. 

All of this is to say that the long term investor may wish to consider more than just the current dividend yield on his investments. He may even be happy to forego incremental increases in the current dividend, but only where opportunities exist for management to put excess cash to use at a high return on equity. 

 

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