Investing in a Dividend Boost

The investment approach rests on these relatively simple concepts:

• Earnings are invested in dividends. Hence the return on the dividend investment can and should be calculated in a manner similar to that used for other investment alternatives. The resulting return can then be compared with the returns expected from alternative investment projects, and appropriate decisions made.
• The “return” from a dividend investment stems from the change in the price/earnings (P/E) ratio that makes it possible to reduce dilution in the case of a merger, acquisition, or new stock issue.
• The effect of a dividend change on a company’s P/E ratio can be estimated through a systematic evaluation of the financial community’s appraisal of the company and its dividend policy compared with similar companies in its industry.
• The effect of a P/E ratio change can be quantified and related to the company’s present and projected funds needs to arrive at an optimum dividend figure. It can then be compared with the historical dividend rate to give stability its due.

This approach is best suited to relatively homogeneous industries such as utilities, petroleum, and so forth; it was extremely useful, for instance, in a recent analysis of a large company in the gas transmission business. But it is also applicable in principle to other industries not so readily related to the money market. And it should be of particular interest to companies with ambitious plans for growth by acquisition.
While these concepts are not difficult, their ease of implementation will vary among companies and industries.

The important point is that every company should carry the analysis as far as possible under the circumstances, making rough estimates, if necessary, to ensure that the relevant factors have been considered and that a suboptimal dividend policy is not continued by default.
The investment approach involves four steps:

For the purpose of this discussion it will be most useful to review each step separately, illustrating it with a somewhat simplified example.

To determine the likely relationship between changes in the percentage payout and the P/E ratio, one should first place the company in perspective within its industry or among other, related companies. Companies in the same industry share many of the same economic risks and are often viewed collectively by the money market.

If allowances are made for individual differences in the expected growth rate of earnings per share (EPS) and of other significant variables within an industry—for example, dept/equity ratios—then reasonable relationships among dividends, earnings, and market price can be determined.

Some assessment of the relationship between the P/E ratio and the dividend payout must be made before the value of a change in dividends can be measured. A realistic relationship over the complete range of payout possibilities for a typical company might logically be expected to resemble that of the hypothetical Synergetic Corporation, shown in Exhibit 1.

Synergetic has a modest P/E ratio (in this case, about 7), with on dividend payout. The market’s estimate is based primarily on growth expectations or liquidation value. In some unusual cases, such as Litton Industries, Inc., the P/E ratio can be quite high when the payout point is zero (excluding stock dividends, of course), so the company is competitive in the money market without making cash dividends.

Synergetic represents a more typical case, in which the company finds it necessary to move to the right along the curve in Exhibit 1 to achieve a competitive P/E ratio. This has been the experience of most corporations in the marketplace.

Low payouts (region A on the graph) may not have any significant effect on Synergetic’s P/E ratio, since the yield is not likely to be competitive with the market or other companies in Synergetic’s industry. This level is insufficient to attract yield-oriented investor’s to the Synergistic stock.

Leverage is important in payout region B as the dividend yield becomes competitive and attracts additional market activity. As the payout reaches region C, Synergetic’s P/E ratio increases at a slower rate until, in region D, the financial community feels that further increases in dividends would be detrimental to the business.

Placing the company in financial perspective in its industry or in a family of financially comparable companies can be done with the aid of “isogrowth” curves – i.e., lines of constant EPS growth rates which relate individual company earnings growth performance to the P/E ratio and the dividend payout. A family of isogrowth curves could look like that in Exhibit II .

Note that in this example the P/E ratios of “growth” companies (15% EPS growth rate or higher) are not influenced as strongly by dividend increases as are those of companies growing less rapidly. At lower growth rates, yield becomes an increasingly significant consideration as investors seeking capital gains lose interest and income-oriented investors become important.

Since P/E ratios generally reflect the market’s opinion concerning future earnings prospects, projections of earnings per share are most useful in determining the relationships of the EPS growth rate and the P/E ratio to the dividend payout.

However, to the extent that past growth rates are viewed as an indication of the future, historical data can be used as a starting point.

Historical data were used successfully in the previously mentioned analysis of the gas transmission company, and a pattern similar to the one in Exhibit II emerged. Modifications can be made to estimates based on historical growth data as appropriate, in order to account for recognized differences in potential.

The position of each company relative to others in its industry or group, which is plotted in Exhibit II , is more important than absolute growth projections; hence unexpected fluctuations of the economy or the specific industry will not invalidate this approach.

The next step is to determine the value of incremental dividend increases in relation to their effect on the P/E ratio. Only in this way can the ultimate return on dividend investments be measured for eventual comparison with other investment alternatives.

Assuming that Synergetic falls on the 5% EPS growth curve from Exhibit II , we can use the curve shown in Exhibit I to determine the effect on various dividend increases on the P/E Ratio.

As can be seen in Exhibit III, there is very little for Synergetic to gain by increasing the dividend payout from 0% to 15%, since little, if any, increase in the P/E ratio occurs in region A of the curve. In region B, the P/E ratio can be increased one unit with less increase dividend payout than it can in any other region. For example:

As Exhibit III shows, if Synergetic’s earnings are $2 per share, the present P/E ratio is 10 (stock price, $20), and the present dividend payout is 40% (80¢ per share), then one P/E unit can be “purchased” with a 5 percentage point (10¢ per share) dividend payout boost. If Synergetic has 5,000,000 shares of stock outstanding, the increase in P/E from 10 to 11 is equivalent to a $10,000,000 (1 times $2 times 5,000,000) increase in stock value. The cost of this $10,000,000 increase is $500,000 (10¢ times 5,000,000 shares).

An incremental increase of one P/E unit might cost $1 million in additional dividends in the C region of Synergetic’s dividend-P/E curve, while in the D region $1 million can be invested with no increase whatsoever—indeed, a negative return may result.

Exhibit IV is another way of illustrating the relationship between P/E levels and the incremental dividend investment required by Synergetic to increase the P/E ratio one unit.

As the exhibit shows, the first 7 P/E units are “free” (i.e., require no dividends). The move from 7 to an 8 P/E ratio would require a $2,500,000 dividend increase, while the move from 10 to 11 would require $500,000. Though not shown on the chart, a 16 P/E ratio cannot be purchased at any price.

In many cases it will not be possible or necessary to estimate the dividend payout-P/E relationship over the complete range of possibilities. The important point is the necessity of making the best possible estimate of the effect on the P/E ratio of changes in dividend payout within the range of the company’s present position.

Once the effect of a dividend increase on the P/E ratio has been estimated, the return on any investment in additional dividends can then be determined by relating dividend value information to the corporation’s present and projected need for funds.

The return from an investment in a dividend increase is the reduction in the number of shares of common stock required to raise a given amount of new capital in the money market, or the improvement in the exchange ratio in an acquisition or merger resulting from the change in the P/E ratio.

The capital saved in this manner is the tangible result of a higher P/E ratio, and the savings can be measured and related to the incremental dividend investment.

Let us return to Synergetic, where we saw that the dividend investment required to move the P/E ratio from 10 to 11 would be $500,000. Each unit increase in P/E is worth $2, for when the in P/E moves from 10 to 11, the stock price moves from $20 per share to $22. Then 250,000 shares (500,000 / 2), or 5% of the total shares outstanding, would have to be used for acquisition purposes, or issued to raise new capital, for Synergetic to “break even.”

It becomes apparent that, to justify “investing” in a higher P/E ratio, the stock intended for a merger or acquisition, or for new capital financing, must represent a fairly significant percentage of a company’s total shares outstanding. The relationship between the percentage of total shares to be used for acquisitions or new financing and the amount Synergetic can invest to increase the P/E ratio one unit is shown in Exhibit V.

As this exhibit shows, if the equivalent 25% of total common shares outstanding is to be used in a given year for acquisitions or issued to raise new equity, Synergetic can pay up to $2,500,000 for each unit increase in the P/E ratio before the break-even point is reached. IF more than $2,500,000 is spent on dividends, a negative return will result.

Putting the information developed in the first three steps together, a return on investment calculation for a specific dividend decision can be made, as shown in the following example:

Assume that Synergetic (EPS, $2; outstanding shares, 5,000,000; current P/E ratio, 10) is planning to exchange 300,000 shares of common stock for acquistitions in the next 12 months. Increasing the P/E from 10 to 11 has a value of $600,000 (EPS of $2 times 300,000 shares). The return on investment is determined by relating the $600,000 value received to the $500,000 investment required to move the P/E from 10 to 11. The ROI is 20%, since:

(($600,000 - $500,000) / $500,000) * 100 = 20%

The above example is somewhat simplified for purposes of explanation, since the effect of only one year was considered. This analysis can be used over a planning horizon longer than a year by applying discounted cash flow techniques to appropriate financial forecasts which spell out the number of shares to be used for acquisitions or new equity capital purposes over a period of time.

In some situations – for example, if Synergetic planned to use about 300,000 shares of stock each year for acquisition purposes—simplified calculations are possible.

To develop the necessary longer-term earnings and capital budget forecasts for this analysis is of course quite difficult in some industries. A company must make an attempt, however, since a decision to increase the regular dividend is a major commitment for an indefinite period. Raising the dividend and then reducing it some time later damages a company’s reputation in the money market.

The attractiveness of a dividend increase can be assessed only by comparing it with other investment opportunities open to the company. If a large number of high-return internal investment opportunities are available, like new plants or products, justifying an investment in a higher dividend payout may be difficult.

A typical distribution of investment projects for Synergetic Corporation might look something like Exhibit VI. Note that the dollar value of available investment projects decreases as the projected return increases.

The 20% return available from Synergetic’s $500,000 investment in an increased dividend is indicated by line A. Assuming sufficient funds are available to undertake all projects indicated by the white area, the dividend investment clearly would be included and should be undertaken.

If, however, Synergetic’s dividend investment analysis indicated a return of 12%, as shown by line B, the dividend investment alternative would not be appropriate in light of the funds available for investment and the other investment projects being considered.

In the example, I evaluted only the first dividend increment (the P/E ratio increase from 10 to 11). To make sure that Synergetic is taking full advantage of its investment opportunities, each incremental dividend increase beyond that should be evaluated until the incremental return on investment drops below the attractive range, which is the white area in Exhibit VI.

This step completes the evaluation of incremental dividend investmentsusing a return on investment framework.

To determine dividend policies, one does not have to rely on intuitive judgement. One approach to considering dividend payout is to analyze it in the same way as other investments. Essentially this involves determining the probable effect of a dividend increase on the P/E ratio.

To determine the return on investment, the savings resulting from an improved merger exchange ratio, or reduced number of shares required for raising a given amount of equity capital, are related to the amount of the dividend investment.

This return is then compared with other available investment alternatives and is selected or rejected on the same basis as other capital investments.

This is a logical, straightforward way of approaching the dividend determination problem.

Although it will be easier to carry out in companies in relatively homogeneous industries, like utilities, it should be reviewed by other publicly held corporations. The approach will be particulatly useful for companies with plans to grow through acquisitions and for companies that are regularly in need of large amounts of new capital.