Many novice investors often choose stocks simply because they pay a higher dividend. Where some part of it is Loss Aversion at play (“If I get money back as soon as possible, I will not lose it”), the primary reason is a lack of understanding about the mechanism through which companies decide the dividend payout.
In this post, we will discuss how companies make the dividend decision and what it means for an investor.
CHOICE OF DISTRIBUTION AND REINVESTMENT
Consider you started a small business 5 years ago. You did not have enough capital so your four friends helped you in that. Each of you owns 20% of the business.
At the end of the recent financial year, the business made a net profit of Rs. 10 lakh after paying all bills and a decent salary to you for managing the business.
What would you do with that money?
Will you distribute the money equally with all your friends i.e. Rs. 2 lakhs each?
Or will you reinvest that money in the business?
Companies face this choice every year. It does not have to be all or nothing. Most companies distribute part of their net income as dividends and the ratio of the amount distributed to the net income is called the Dividend Payout Ratio.
For example, if you decide to distribute Rs. 5 lakhs and reinvest the other half then the Dividend Payout Ratio is 50%.
WHAT INFLUENCES THE DECISION?
How would you decide how much money to reinvest and how much to distribute? For a company, it is about the best utilisation. Consider that you think that you need to invest at least Rs. 2 lakhs to maintain the sales and Rs. 5 lakhs of further investment can increase the profits of the business by 20%. Now, if you decide to reinvest the Rs. 7 lakhs from the business, you can distribute the rest Rs. 3 lakhs i.e. a Payout Ration of 30%.
The choice of Dividend Payout Ratio depends on the available investment opportunities for the business. Availability of the investment opportunities depends on many factors including the growth prospects of the market, the growth prospects of the company, expected macroeconomic conditions etc.
In short, a higher Dividend Ratio means that the company does not have enough investment opportunities for future growth. This generally happens for matured companies in saturated markets.
WHAT DOES IT MEAN FOR AN INVESTOR?
For an investor who is looking for growth in their portfolio, high dividend paying stocks may not be the right choice. In the long run, the sustainable growth rate of a company gets influenced by the Dividend Payout Ratio as follows
Sustainable Growth Rate = ROE X (1- Dividend Payout Ratio)
ROE = Return on Equity
ROE shows the ability of the company to convert equity investments into net income. ROE is a combined effect of the ability to generate revenue, profitability and financial leverage.
As mentioned before, a higher Dividend Payout Ratio often means a lower growth prospect for the company and in turn the share price of the company.