Conscious Investor Knowledge Base

Why do STRET and STRETD always increase when the payout ratio is increased?

When a company has a high return on equity and return on capital it is generally better that they do not pay dividends since it is likely that they will do better with the money than you will. Berkshire Hathaway is an example of a company that pays no dividends and this is the way the investors like it.

So at first it may seem odd that STRETD always goes up when the payout ratio is increased.

The explanation is that there are two sources of wealth, dividends and capital gains. The capital gains come from growth in share price which is estimated by forecasting growth rate of earnings and the P/E ratio. This has nothing to do with dividends. The wealth from dividends comes from the accumulation of dividends, which are estimated using the payout ratio.

If you increase the payout ratio, leaving everything else fixed, you are assuming that the share price is going to continue to grow at the same rate, AND the dividends are going to increase. Clearly in this case you would expect STRETD to increase.

In practice, if the payout ratio increases then the growth rate of earnings will decrease. The extreme case is when the payout ratio is 100%. When this happens, without extra borrowings or dramatic increases in efficiency, you would expect the growth rate of earnings to be zero or close by.

For those who like to see things via examples, here is an illustration.

Consider two companies, A and B, both with price $20, a constant PE of 20 and earnings growth of 10%. Suppose that A has a 100% payout ratio and B has a 0% payout ratio.

Then A is the better investment since it is growing its earnings while maintaining high dividends. Here are the details.

Company A:

Current situation: Price $20, EPS $1.00

After one year: EPS = $1.10,

Price = 20 x 1.10 = $22,
Dividend = 100% of $1.10 = $1.10

Hence wealth = $22 + $1.10 = $23.10

Total return = 23.10 / 20 -1 = 15.5%

Company B:

Current situation: Price $20, EPS $1.00

After one year: EPS = $1.10,

Price = 20 x 1.10 = $22,
Dividend = 0% of $1.10 = $0

Hence wealth = $22 + $0= $22.00

Total return = 22 / 20 -1 = 10%

 




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Last Updated
24th of January, 2014

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