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What is Dividend?
Before getting into the details of dividend yield against dividend payout it is important to break down the concept of the dividend. The dividend, most simplistically, is the distribution of profits of the company among the shareholders. It is generally declared at regular intervals which may be monthly, quarterly or annually. Also, dividends are expressed as a percentage of the nominal value of the stock.
For example, Roman Inc has a share capital comprising of stocks issued at a nominal value of $10. The stocks currently trade at $50 on the NYSE. The directors of the company declared a dividend of 50%. Therefore the dollar value of the dividend declared is ($10* 50%) $5.
Difference between Dividend Yield Vs. Payout
The two terms may sound interchangeable and closely related at a glance. However, it is not even remotely so. Dividend yield refers to the rate of return earned by the shareholders on their investment. Whereas the dividend payout ratio represents that portion of the earnings which the company distributes as a dividend.
|Dividend Yield||Dividend Payout|
|Aids investor in decision making||Decision at the discretion of the company|
|Compares dividend with the market price of the stock||Compares dividend with the earnings|
|Relevant parameter for investors who prefer income stocks with a regular stream of cash flows||Relevant parameter for investors who prefer growth stocks|
It is a financial ratio that indicates the percentage of cash dividends received as against the market price of the stock. This ratio is highly relevant from the investor’s perspective. It seeks to express the return earned on every dollar invested into the stock of the company.
Dividend Yield = Dividend per share/ Market Price per share * 100%
Borrowing from the previous example, the dividend yield for a stockholder of Roman Inc will be $5/$50 * 100% i.e., 10%
High & Low Yield Stocks
On the basis of dividend strategy of an organization, it is possible to classify the stocks as high and low yield. Both categories cater to the requirements of different classes of investors.
High Yield Stocks
While it appears to be a very lucrative form of investment, it may not necessarily be so. High yielding stocks pay out a large chunk of their earnings as a dividend. This is also why they are referred to as income-stocks. Such stocks do not demonstrate an inclination towards growth since they distribute the better part of their earnings instead of reinvestment.
On the contrary, high yield stocks also represent stability in profits and earning potential of the company. Analysts consider them to be “safer” investments for the same reason. High yielding stocks are the preferred investment type for investors who prefer a steady stream of income.
Low Yield Stocks
Unlike its counterpart, these stocks do not distribute huge portions of its profit. Stringent dividend policies allow the company to reinvest earnings to fuel its growth potential. They are therefore known as growth stocks. Such stocks reap little or no dividend. But they provide ample return to the shareholders in the form of increased stock prices. Investors who prefer such stocks generally have a long-term horizon and no requirement for recurring cash flows
The dividend payout ratio represents that portion of earnings which is distributed as dividends to the shareholders. The earnings refer to the net income which remains after providing for external liabilities such as interest and taxes. The payout ratio is an extremely useful one since it is indicative of several factors. Some of these include the company’s financial health, future outlook, and level of maturity.
Dividend payout ratio = Dividend per share /Earnings per share
Extending from the previous example, Roman Inc has a share capital comprising of 100,000 shares. And it reports total earnings after tax of $20,000,000. Therefore its EPS equals ($20,000,000 / 100,000) $200 per share. Dividend per share is $50. Thus the dividend payout ratio is ($50/$200) 0.25 or 25%.
The understanding of dividend payout is incomplete without the retention ratio. The payout and retention ratio are two sides of the same coin. Retention ratio represents that portion of the total earnings which are not available or distribution by the company. They are plowed back for expansion and growth. It is this dynamic which is ultimately responsible to determine the growth potential of the company. The formula below seeks to explain the same:
g = b * r
Where, g= growth; b= total earnings; r = retention ratio.
Therefore the above equation makes the affirmation that the growth is a direct function of the quantum of earnings reinvested into future operations. However, this proposition may only hold true when the company is actually confronted with high yielding investments. Diverting earnings to such avenues will help the company to earn higher rates of return. Which consequentially increases the price of stocks.
On the contrary, the companies not in growth phase should consider having a higher payout ratio. This prevents the funds from lying idle or being invested in projects which prove to be detrimental to the value of the company. This would unexceptionally have the impact of driving down the stock prices.
Drivers of Dividend Payout Ratio
- The phase of maturity cycle: Established companies may have higher payout ratios than companies in development or growth phase. This is because smaller companies prefer to reinvest their earnings to fuel faster growth.
- Industry: Industry parameters greatly influence the payouts. For example, REITs are subject to statutory requirements to dispose of fixed % of earnings. Volatile industries such as technology and pharma may pay from little to no dividend. Stable and mature sectors such as banking and insurance may pay a steady rate of dividend.
- Business Climate: In periods of economic boom the company may choose to share the increased profits with the shareholders by declaring a high payout ratio. However, such an increase may not be sustainable.
The Ideal Scenario
When viewed in conjunction with one another, a high dividend yield and low payout ratio would be optimum. On the other hand, a low dividend yield and a high payout ratio are not considered to be appealing.
To break down this assertion, a high dividend yield ensures a satisfactory return on investment to the investor. The low payout ratio implies that the company while providing for dividend has ensured to retain a considerable chunk of earnings. This ensures both, attractiveness to investors as well as bright growth prospects for the company.
References: Strategic Financial Management, CA Final Syllabus; Equity, CFA L I & II, CFA CurriculumLast updated on : May 25th, 2018