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    
          (1-p)

 g = ROE * (1-p) 
          

Example:
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?

Answer:
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, 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.

Setting Dividends

Related Articles
  1. Investing

    Why Dividends Matter

    Seven words that are music to investors' ears? "The dividend check is in the mail."
  2. Investing

    The 3 Biggest Misconceptions of Dividend Stocks

    To find the best dividend stocks, focus on total return, not yield.
  3. Investing

    AAPL: Apple Dividend Analysis

    Apple's dividend has had healthy growth ever since its 2012 reinstatement, thanks to Apple's continuously rising revenue, earnings and operating cash flow.
  4. Investing

    Due Diligence On Dividends

    Understanding dividends and how they work will help you become a more informed and successful investor.
  5. Investing

    How Dividends Affect Stock Prices

    Find out how dividends affect the price of the underlying stock, the role of market psychology and how to predict price changes after dividend declaration.
  6. Investing

    How And Why Do Companies Pay Dividends?

    If a company decides to pay dividends, it will choose one of three approaches: residual, stability or hybrid policies. Which a company chooses can determine how profitable its dividend payments ...
  7. Investing

    WMT: Wal-Mart Dividend Analysis

    Wal-Mart raised its dividend for the 43rd consecutive year, despite losing over 25% of its market value in 2015, and its dividend remains healthy in 2016.
Frequently Asked Questions
  1. How can the price-to-earnings (P/E) ratio mislead investors?

    A low P/E ratio doesn't automatically mean a stock is undervalued, just like a high P/E ratio doesn't necessarily mean it ...
  2. What are the main differences between compound annual growth rate (CAGR) and internal rate of return (IRR)?

    The compound annual growth rate (CAGR), measures the return on an investment over a certain period of time. The internal ...
  3. What are the differences between gross profit and gross margin?

    Learn how gross profit and gross margin are calculated and how each is used in fundamental analysis. Generally, these numbers ...
  4. How do I calculate the adjusted closing price for a stock?

    When trading is done for the day on a recognized exchange, all stocks are priced at close. The price that is quoted at the ...
Trading Center