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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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Dividend increase value |
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The next step is to determine the value of incremental dividend increases in relation to their effect on the P/E ratio. Only in this way can the ultimate return on dividend investments be measured for eventual comparison with other investment alternatives.
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Assuming that Synergetic falls on the 5% EPS growth curve from Exhibit II, we can use the curve shown in Exhibit I to determine the effect on various dividend increases on the P/E Ratio.
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As can be seen in Exhibit III, there is very little for Synergetic to gain by increasing the dividend payout from 0% to 15%, since little, if any, increase in the P/E ratio occurs in region A of the curve. In region B, the P/E ratio can be increased one unit with less increase dividend payout than it can in any other region. For example:
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As Exhibit III shows, if Synergetic’s earnings are $2 per share, the present P/E ratio is 10 (stock price, $20), and the present dividend payout is 40% (80¢ per share), then one P/E unit can be “purchased” with a 5 percentage point (10¢ per share) dividend payout boost. If Synergetic has 5,000,000 shares of stock outstanding, the increase in P/E from 10 to 11 is equivalent to a $10,000,000 (1 times $2 times 5,000,000) increase in stock value. The cost of this $10,000,000 increase is $500,000 (10¢ times 5,000,000 shares).
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An incremental increase of one P/E unit might cost $1 million in additional dividends in the C region of Synergetic’s dividend-P/E curve, while in the D region $1 million can be invested with no increase whatsoever—indeed, a negative return may result.
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Exhibit IV is another way of illustrating the relationship between P/E levels and the incremental dividend investment required by Synergetic to increase the P/E ratio one unit.
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As the exhibit shows, the first 7 P/E units are “free” (i.e., require no dividends). The move from 7 to an 8 P/E ratio would require a $2,500,000 dividend increase, while the move from 10 to 11 would require $500,000. Though not shown on the chart, a 16 P/E ratio cannot be purchased at any price.
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In many cases it will not be
possible or necessary to estimate the dividend payout-P/E relationship over the complete range of possibilities. The important point is the necessity of making the best possible estimate of the effect on the P/E ratio of changes in dividend payout within the range of the company’s present position.
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