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Investing in a Dividend Boost |
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Havard Business Review |
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July - August 1967 |
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By Gary MacDougal |
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Page 1 2 3 4 5 6 |
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Simple concepts |
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The investment approach rests on these relatively simple concepts:
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Earnings are invested in dividends. Hence the return on the dividend investment can and should be calculated in a manner similar to that used for other investment alternatives. The resulting return can then be compared with the returns expected from alternative investment projects, and appropriate decisions made. |
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The “return” from a dividend investment stems from the change in the price/earnings (P/E) ratio that makes it possible to reduce dilution in the case of a merger, acquisition, or new stock issue. |
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The effect of a dividend change on a company’s P/E ratio can be estimated through a systematic evaluation of the financial community’s appraisal of the company and its dividend policy compared with similar companies in its industry. |
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The effect of a P/E ratio change can be quantified and related to the company’s present and projected funds needs to arrive at an optimum dividend figure. It can then be compared with the historical dividend rate to give stability its due.
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This approach is best suited to relatively homogeneous industries such as utilities, petroleum, and so forth; it was extremely useful, for instance, in a recent analysis of a large company in the gas transmission business. But it is also applicable in principle to other industries not so readily related to the money market. And it should be of particular interest to companies with ambitious plans for growth by acquisition.
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While these concepts are not difficult, their ease of implementation will vary among companies and industries.
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Four Steps
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The important point is that every company should carry the analysis as far as possible under the circumstances, making rough estimates, if necessary, to ensure that the relevant factors have been considered and that a suboptimal dividend policy is not continued by default.
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| The investment approach involves four steps: |
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Placing the company in perspective in its industry to determine the most likely relationship between the P/E ratio and the dividend payout. |
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Calculating the value of varying dividend levels by relating payouts to their effect on the P/E ratio. |
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Relating dividend value information to the company’s present and projected needs for funds to determine the return at varying dividend payouts. |
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Comparing these dividend returns on investment projections with the returns expected from other investment opportunities available to the company to determine the optimum dividend amount. |
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For the purpose of this discussion it will be most useful to review each step separately, illustrating it with a somewhat simplified example.
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