Dividend and Earnings Growth
by MaestriGrowth in dividends occurs primarily as a result of growth in earnings per share (EPS). Earnings growth, in turn, results from a number of factors, including (1) inflation, (2) the amount of earnings the company retains and reinvests, and (3) the rate of return the company earns on its equity (ROE). Regarding inflation, if output (in units) is stable, but both sales prices and input costs rise at the inflation rate, then EPS will also grow at the inflation rate. Even without inflation, EPS will also grow as a result of the reinvestment, or plowback, of earnings. If the firm’s earnings are not all paid out as dividends (that is, if some fraction of earnings is retained), the dollars of investment behind each share will rise over time, which should lead to growth in earnings and dividends. Even though a stock’s value is derived from expected dividends, this does not necessarily mean that corporations can increase their stock prices by simply raising the current dividend. Shareholders care about all dividends, both current and those expected in the future. Moreover, there is a trade-off between current dividends and future dividends. Companies that pay high current dividends necessarily retain and reinvest less of their earnings in the business, and that reduces future earnings and dividends.
So, the issue is this: Do shareholders prefer higher current dividends at the cost of lower future dividends, the reverse, or are stockholders indifferent? There is no simple answer to this question. Shareholders prefer to have the company retain earnings, hence pay less current dividends, if it has highly profitable investment opportunities, but they want the company to pay earnings out if investment opportunities are poor.Taxes also play a role—since dividends and capital gains are taxed differently, dividend policy affects investors’ taxes.We will consider dividend policy in detail in Chapter 14.
Taken From : Five-Minute MBA – Corporate Finance
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