Stock Valuation

Relationship Between Dividend Payments and the Growth Rate

Ideally, the portion of earnings not paid to investors is left for investment to provide for future earnings growth.

From an investor's point of view, the fundamentals of a company are of the utmost importance. One such fundamental factor that investors consider is how much capital is distributed to investors and, conversely, how much capital is kept from investors. Capital is distributed to investors via dividend payments and indirectly through capital gains. Capital that is kept from investors is known as retained earnings. Investors hope that firms will use retained earnings to either maximize their current operations or invest in such a way as to lead to higher profits. In other words, the portion of profits not paid out to investors via dividends is, ideally, left for investment to provide for future earnings growth.

Some companies require large amounts of new capital just to continue operations. Such firms usually cannot distribute earnings since their funds are tied up in maintenance, repairs, etc. These companies also provide limited growth opportunities since earnings are not reinvested for the purpose of growth. On the other hand, some companies can retain earnings and put that money back to work – i.e., invest in growth opportunities. Firms that can do this tend to retain more of their earnings. These firms are attractive to investors, even though there is relatively low distribution of profits.

Put succinctly, investors seeking high current income and limited capital growth prefer companies with a high dividend payout ratio. However, investors seeking higher capital growth may prefer a lower payout ratio because capital gains are taxed at a lower rate. High-growth firms in early life generally have low or zero payout ratios to reinvest as much of their earnings as possible. As they mature, they tend to return more of the earnings back to investors. Note that the dividend payout ratio is calculated as dividend per share divided by earnings per share.