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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 ROI |
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Once the effect of a dividend increase on the P/E ratio has been estimated, the return on any investment in additional dividends can then be determined by relating dividend value information to the corporation’s present and projected need for funds.
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The return from an investment in a dividend increase is the reduction in the number of shares of common stock required to raise a given amount of new capital in the money market, or the improvement in the exchange ratio in an acquisition or merger resulting from the change in the P/E ratio.
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The capital saved in this manner is the tangible result of a higher P/E ratio, and the savings can be measured and related to the incremental dividend investment.
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Let us return to Synergetic, where we saw that the dividend investment required to move the P/E ratio from 10 to 11 would be $500,000. Each unit increase in P/E is worth $2, for when the in P/E moves from 10 to 11, the stock price moves from $20 per share to $22. Then 250,000 shares (500,000 / 2), or 5% of the total shares outstanding, would have to be used for acquisition purposes, or issued to raise new capital, for Synergetic to “break even.”
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It becomes apparent that, to justify “investing” in a higher P/E ratio, the stock intended for a merger or acquisition, or for new capital financing, must represent a fairly significant percentage of a company’s total shares outstanding. The relationship between the percentage of total shares to be used for acquisitions or new financing and the amount Synergetic can invest to increase the P/E ratio one unit is shown in Exhibit V.
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As this exhibit shows, if the equivalent 25% of total common shares outstanding is to be used in a given year for acquisitions or issued to raise new equity, Synergetic can pay up to $2,500,000 for each unit increase in the P/E ratio before the break-even point is reached. IF more than $2,500,000 is spent on dividends, a negative return will result.
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Putting the information developed in the first three steps together, a return on investment calculation for a specific dividend decision can be made, as shown in the following example:
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Assume that Synergetic (EPS, $2; outstanding shares, 5,000,000; current P/E ratio, 10) is planning to exchange 300,000 shares of common stock for acquistitions in the next 12 months. Increasing the P/E from 10 to 11 has a value of $600,000 (EPS of $2 times 300,000 shares). The return on investment is determined by relating the $600,000 value received to the $500,000 investment required to move the P/E from 10 to 11. The ROI is 20%, since:
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(($600,000 - $500,000) / $500,000) * 100 = 20%
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The above example is somewhat simplified for purposes of explanation, since the effect of only one year was considered. This analysis can be used over a planning horizon longer than a year by applying discounted cash flow techniques to appropriate financial forecasts which spell out the number of shares to be used for acquisitions or new equity capital purposes over a period of time.
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In some situations – for example, if Synergetic planned to use about 300,000 shares of stock each year for acquisition purposes—simplified calculations are possible.
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To develop the necessary longer-term earnings and capital budget forecasts for this analysis is of course quite difficult in some industries. A company must make an attempt, however, since a decision to increase the regular dividend is a major commitment for an indefinite period. Raising the dividend and then reducing it some time later damages a company’s reputation in the money market.
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Page 4 Page 6
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