Intuitively, high dividends are desirable for stockholders, but low payout ratios can be good too. Low payouts can mean the company is growing rapidly and has the potential for high total returns. The payout ratio tells you what percentage of a company’s earnings are paid out as dividends. Dividing the dividend by the stock’s price will provide a current estimate of the dividend yield. In general, the higher the payout ratio is, the higher the dividend yield will be.
Payout Ratios and Industry Cycles
Net income -- company earnings -- can be either paid out to stockholders as dividends or plowed back in to the firm for future growth. When companies are young and growing, company earnings will often grow more quickly if they are reinvested in the company instead of being paid out to shareholders in the form of dividends. Shareholders will be better off if the company policy is to mainitain a low payout ratio because the growth in company earnings will be reflected in higher future stock prices. In contrast, payout ratios tend to be higher for mature firms and companies in mature industries because there are fewer opportunities for growth within the company or industry. For mature firms, shareholder wealth is maximized by paying out a higher portion of earnings to the investors as dividends.
Payout Ratios, Growth and Signals
Since earnings are divided into those reinvested in a company and those paid out to stockholders, the reinvestment ratio is defined as 100 percent minus the payout ratio. The growth in dividends can be estimated by multiplying the reinvestment ratio by the return on equity. Return on equity measures how profitably a company is performing over a certain time frame compared to the equity that common shareholders have in it. For example, if return on equity is 10 percent, and the reinvestment ratio is 50 percent, the dividends theoretically will grow by 5 percent each year, assuming that all variables are held constant. In reality, companies try to keep their dividend amounts relatively constant and let the payout ratio vary with earnings. This is because a decrease in dividends may be a bad signal if interpreted by investors as an inability to maintain dividends in the future.
Stock Dividend Yields and Total Return
For low payout ratios, most of the stockholder’s return is in the form of share price appreciation. If there are no dividends, the total return on a stock is found by dividing the growth in the value of the stock by the amount invested. For example if you purchased a stock at $100 and sold it for $110, your total return is $10 divided by $100, or 10 percent. If the stock also paid you a dividend of $1, you would include the dividend as part of your earnings, so the total return would be 11 percent. This is the sum of the dividend yield of 1 percent and the capital gains yield of 10 percent.
Economic Cycles and Low versus High Dividend Paying Stocks
High-dividend paying stocks come in and out of vogue, as do high-growth stocks. During the internet bubble and other periods of rapid economic growth, investors were not concerned with dividends. They wanted to participate in the rapid increase in stock prices. For years after the financial crisis in 2008, investors were unsure about stock price growth and sought out mature companies with stable dividends. Differential tax rates for capital gains and dividends can also impact investor preferences.
- Essentials of Investments: Zvi Bodie, Alex Kane and Alan J.Marcus
Kathryn Christopher has been writing about investments for more than 20 years. Her work has appeared in the "Journal of Alternative Investments" and numerous other academic and industry publications. She works at Wiggin Financial Planning, teaches for UMASSOnline from South Florida, and holds a PhD in finance from the University of Massachusetts.