Dividend Payout Ratio and Earnings Growth

I have always been under the impression that a dividend payout ratio must not be too high because it can limit the ability of the company to grow. In fact, in my weekly dividend stock analysis posts, I look for a dividend payout ratios that are at least below 60%, preferably even lower. I have selected this target because I have believed that the lower payout ratio will provide the company with a sizable chunk of earnings to grow the business and with a lower than 60% dividend payout ratio a company can continue to grow its dividend even during time of economic slowdowns or reduced earnings. It appears that this theory and fundamental analysis principle has been refuted in a study by Robert D. Arnott and Clifford S. Asness (pdf document). Their theory is that higher dividend payouts actually have lead to higher earnings growth. And with higher earnings growth, share prices tend to go up over time which is better for all of us investors. Let’s have a look at their research and findings.

…But First a Definition of the Payout Ratio

The payout ratio is the percentage of a company’s earnings that are paid out as dividends. In a nutshell, the payout ratio provides an idea of how well earnings support the dividend payments. More mature companies tend to have a higher payout ratio.

Support for Higher Dividend Payout Ratios and Earnings Growth

The crux of the Arnott and Asness research really boils down to one chart in the 87 page report. Being the good guy that I am :-) I will summarize the report by presenting this chart to you. Have a look and it is clear that there is a trend happening here.

Dividend Payout Ratio and Earnings GrowthClick to Enlarge

As you can see, for a high number of companies, the higher the payout ratio is the better earnings growth the companies experienced. Here are some comments from the authors:

In general, when starting from very low payout ratios, the equity market has delivered dismal real earnings growth over the next decade; growth has actually fallen 0.4 percent a year on average–ranging from a worst case of truly terrible –3.4 percent compounded annual real earnings for the next 10 years to a best case of only 3.2 percent real growth a year over the next decade. From a starting point of very high payout ratios, the opposite has occurred: strong average real growth (4.2 percent), a worst case of positive 0.6 percent, and a maximum that is a spectacular 11.0 percent real growth a year for 10 years.

So what do we, the average investors (no offense to anyone) do with this data? My view is that I am going to continue to use my 60% payout ratio benchmark, but will not scoff at a higher dividend payout ratio as quickly. I still believe that it is the average historical payout ratio that an investor must be concerned with – any recent jumps in the payout ratio need to be examined to determine why the change occurred. Let me know what you think we should do – I am looking for your comments using the comment section below.

(Photo Credit: Sufi Nawaz)

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18 Comments   |  

18 Comments

April 6, 2008, 8:06 am

Great read! I think you hit on it when you said:

> any recent jumps in the payout ratio need to be examined to determine why the
> change occurred.

I don’t focus so much on the level as I do the change or consistency.

Best Wishes!

April 6, 2008, 10:50 am

This is very interesting. I would have never guessed this to be the case. Did the researchers hypothesize why this was happening?

April 6, 2008, 11:18 am

One thing I’ve always wondered about is why Warren Buffet won’t pay a dividend. Isn’t owning his stocks much like owning a house it keeps increasing in value but doesn’t pay anything. You can be rich with but have not cash flow short of selling the shares. I own dividend stocks with the idea that they will provide a retirement income.

April 6, 2008, 6:42 pm

I agree with dividenddollar, this is surprising..

April 7, 2008, 6:09 am

I think what is key, as Josh Peters points out in his book, is setting a div payout ratio that is high but sustainable through a couple of years of tough times. At the limit, a firm paying 100% of earnings as dividends would not be able to sustain this dividend through even a moderate downturn. Josh describes a method for figuring out the safety of the dividend taking into account funds required to grow the company and further, the impact of this growth on the expected growth of the dividend. A great (must) read for all dividend investors.

April 7, 2008, 7:26 am

[...] yesterday’s post I floated the alternative view that high dividend payouts lead to better earnings for a [...]

April 7, 2008, 9:00 am

[...] Dividend Guy presents High Dividend Payout Ratio = High Earnings Growth Rate, and says, “This post looks at that research to see how we as investors should deal with high [...]

April 7, 2008, 9:55 am

This is a very interesting analysis. I am not a big fan of large dividend payout ratios ( over 50%). I feel that the dividend growth is threatened by a high DPR. And there’s other research that shows that slow dividend growth equates to management exepcting slower EPS growth.
Anyways, I can’t open the article ( cookies problem) so i was wondering how they picked their sample and what period was this study concerned with?

April 7, 2008, 6:04 pm

Where would I find the dividend payout ratio? I have three stocks that they all pay dividends but just starting to learn how to understand their reports.

April 7, 2008, 6:39 pm

This surprises me as well. To exacerbate the shortcoming of low payout stocks, investors have less reinvestable dividends to compound growth. From my experience, I haven’t noticed a possitive correlation between earning growth and payout ratio.

April 8, 2008, 9:34 am

I just did some additional computations on the stocks which I have analyzed so far on my blog. It seems to me that over the past 10 years the majority of stocks with DPR of over 50% had subpar total returns to shareholders. In periods when stocks had DPR of less than 50%, the majority of stocks had superior total investment returns than the high dividend payout years.
I will try to post this soon..
I guess the academicians should also test the link between earnings growth and stock performance.

April 9, 2008, 10:33 am

[...] High Dividend Payout Ratio = High Earnings Growth Rate @ The Dividend Guy [...]

April 9, 2008, 10:43 pm

[...] Dividend Guy recently touched on a research paper that revealed a surprising result about dividend investing; [...]

April 11, 2008, 6:31 am

[...] The Carnival of Personal Finance at MoneyNing included my article High Dividend Payout Ratio = High Earnings Growth Rate. [...]

TOM PATANE
November 21, 2008, 2:28 pm

Many people use the earnings payout ratio (dividends per share / earnings per share) to evaluate if a business is strong. So finding such data is easy.

But those numbers aren’t always reliable because a company can strategically adjust net income for any number of reasons.

Can anyone please suggest a source for FREE CASH FLOW payout ratios??

Thanks!
SDANIS@NYC.RR.COM

Hans Alarcon
April 14, 2009, 11:08 am

Some companies use as an excuse of not paying cash dividends the idea of investing in projects which should increase the price of the stocks in the future. In this article the researchers try to say that that explanation it’s not so true and some managers are actually looking to have some earnings for themselves in a form of an increase in salary, for example.

The link to CFA Institute served me for some research I’m doing at Uni. Thanks for that.

June 21, 2009, 12:22 am

Could be a case of survivorship bias. There are only 20 samples in the high POR high Div Growth category, according to the scatter chart. Perhaps another bunch went bankrupt. Common sense would suggest so.

April 17, 2012, 12:43 am

I have believed that the lower payout ratio will provide the company with a sizable chunk of earnings to grow the business and with a lower than 60% dividend payout ratio a company can continue to grow its dividend even during time of economic slowdowns or reduced earnings.

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