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Concept Version 12
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Relationship Between Dividend Payments and the Growth Rate

The portion of the earnings not paid to investors is, ideally, left for investment in order to provide for future earnings growth.

Learning Objective

  • Describe the relationship between dividend payments and a company's growth


Key Points

    • Investors take into account how much capital is distributed to investors, and conversely how much capital is kept from investors.
    • Investors hope that firms will use retained earnings to either maximize their current operations or invest in such as a way as to lead to higher profits.
    • Some firms are unable to distribute earnings, since their funds are tied up in maintenance, repairs, et cetera.
    • On the other hand, some companies can retain earnings and put that money back to work - i.e., invest in growth opportunities.

Term

  • capital gains

    Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to arbitrage.


Full Text

From an investor's point of view, the fundamentals of a company are of the utmost importance. One such fundamental that that investors take into account 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 as 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 in order to provide for future earnings growth.

Some companies require large amounts of new capital just to continue operations. Such firms are usually unable to distribute earnings, since their funds are tied up in maintenance, repairs, et cetera. 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 in order 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 dividend payout ratio is calculated as dividend per share divided by earnings per share.

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