Monday, October 24, 2011

Dividend Growth Rate and the Effect of Changing Dividend Policy

CFA Level 1 - Corporate Finance

Calculating a Company's Implied Dividend Growth Rate
Recall that a company's ROE is equal to a company's earnings growth rate (g) divided by one minus a company's payout rate (p).

Formula 11.21

ROE =        g___ or,   g = ROE * (1-p)

Let's assume Newco's ROE is 10% and the company pays out roughly 20% of its earnings in the form of a dividend. What is Newco's expected growth rate in earnings?

g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)g = 8%

Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth rate in earnings is 8%.

Signaling An Earning's Forecast Through Changes in Dividend Policy
Much like a company can signal the state of its operations through its use of capital-financing projects, management can also signal its company's earnings forecast through changes in its dividend policy.
Dividends are paid out when a company satisfies its internal needs for cash. If a company cuts its dividends, stockholders may become worried that the company is not generating enough earnings to satisfy its internal needs for cash as well as pay out its current dividend. A stock may decline in this instance. 
Suppose for example Newco decides to cuts its dividend to $0.25 per share from its initial value of $0.50 per share. How would this be perceived by investors?
Most likely the cut in dividend by Newco would be perceived negatively by investors. Investors would assume that the company is beginning to go through some tough times and the company is trying to preserve cash. This would indicate that the business may be slowing or earnings are not growing at the rate it once had.

To learn more about dividends, please read: The Importance of Dividends

The Clientele Effect.
A company's change in dividend policy may impact in the company's stock price given changes in the "clientele" interested in owning the company's stock. Depending on their personal tax situation, some stockholders may prefer capital gains over dividends and vice versa as capital gains are taxed at a lower rate than dividends. The clientele effect is simply different stockholders' preference on receiving dividends compared to capital gains.

For example, a stockholder in a high tax bracket may favor stocks with low dividend payouts compared to a stockholder in a low tax-bracket who may favor stocks with higher dividend payouts.

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