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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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Company in perspective |
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To determine the likely relationship between changes in the percentage payout and the P/E ratio, one should first place the company in perspective within its industry or among other, related companies. Companies in the same industry share many of the same economic risks and are often viewed collectively by the money market.
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If allowances are made for individual differences in the expected growth rate of earnings per share (EPS) and of other significant variables within an industry—for example, dept/equity ratios—then reasonable relationships among dividends, earnings, and market price can be determined.
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Some assessment of the relationship between the P/E ratio and the dividend payout must be made before the value of a change in dividends can be measured. A realistic relationship over the complete range of payout possibilities for a typical company might logically be expected to resemble that of the hypothetical Synergetic Corporation, shown in Exhibit 1.
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Synergetic has a modest P/E ratio (in this case, about 7), with on dividend payout. The market’s estimate is based primarily on growth expectations or liquidation value. In some unusual cases, such as Litton Industries, Inc., the P/E ratio can be quite high when the payout point is zero (excluding stock dividends, of course), so the company is competitive in the money market without making cash dividends.
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Synergetic represents a more typical case, in which the company finds it necessary to move to the right along the curve in Exhibit 1 to achieve a competitive P/E ratio. This has been the experience of most corporations in the marketplace.
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Low payouts (region A on the graph) may not have any significant effect on Synergetic’s P/E ratio, since the yield is not likely to be competitive with the market or other companies in Synergetic’s industry. This level is insufficient to attract yield-oriented investor’s to the Synergistic stock.
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Leverage is important in payout region B as the dividend yield becomes competitive and attracts additional market activity. As the payout reaches region C, Synergetic’s P/E ratio increases at a slower rate until, in region D, the financial community feels that further increases in dividends would be detrimental to the business.
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Placing the company in financial perspective in its industry or in a family of financially comparable companies can be done with the aid of “isogrowth” curves – i.e., lines of constant EPS growth rates which relate individual company earnings growth performance to the P/E ratio and the dividend payout. A family of isogrowth curves could look like that in Exhibit II.
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Note that in this example the P/E ratios of “growth” companies (15% EPS growth rate or higher) are not influenced as strongly by dividend increases as are those of companies growing less rapidly. At lower growth rates, yield becomes an increasingly significant consideration as investors seeking capital gains lose interest and income-oriented investors become important.
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Since P/E ratios generally reflect the market’s opinion concerning future earnings prospects, projections of earnings per share are most useful in determining the relationships of the EPS growth rate and the P/E ratio to the dividend payout.
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However, to the extent that past growth rates are viewed as an indication of the future, historical data can be used as a starting point.
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Historical data were used successfully in the previously mentioned analysis of the gas transmission company, and a pattern similar to the one in Exhibit II emerged. Modifications can be made to estimates based on historical growth data as appropriate, in order to account for recognized differences in potential.
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The position of each company relative to others in its industry or group, which is plotted in Exhibit II, is more important than absolute growth projections; hence unexpected fluctuations of the economy or the specific industry will not invalidate this approach.
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