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Learning outcomes.

Â After watching this video you will be able to relate earnings growth

Â rate to dividend growth rate.

Â Determine when increasing the retention rate will increase stock price and

Â when it will decrease stock price.

Â The growth rate of dividends.

Â Last time, we saw that one realistic way to calculate today's stock

Â price was to treat the dividend stream as a growing perpetually and

Â then use the garden growth model to calculate today's price.

Â But how do we go about determining what the growth rate of dividends will be?

Â Let's define the dividend payout rate as the fraction

Â of a company's earnings paid out as dividends each year.

Â The dividend per share for the company will be the company's earnings, or

Â net income, for

Â the year divided by the shares outstanding times the dividend payout rate.

Â A company can potentially increase it's dividends per share by

Â increasing earnings, increasing the dividend payout rate,

Â or decreasing it's shares outstanding.

Â Let's keep the shares outstanding fixed and

Â look at only the trade-off between earnings and the dividend payout rate.

Â A company can do two things with its earnings.

Â Pay them out as dividends or retain them and reinvest them in the company.

Â Let's also assume that the company does not grow if there is no investment.

Â Any change in earnings may be attributed to the amount of the new

Â investment made and the return that it earns.

Â This can be returned as change in earning equals new investments

Â made by the company times the return on the new investment.

Â New investments made by the company is, itself,

Â equal to its earnings times the retention rate,

Â where the retention rate is 1 minus the dividend payout rate.

Â Substituting new investments in the equation for

Â change in earnings, gives us change in earnings,

Â equals earnings times retention rate, times return on new investment.

Â Dividing through by earnings gives us the change in earnings over earnings.

Â Which is the Earnings Growth Rate = Retention Rate x Return on new investment.

Â If the company chooses to keep its dividend payout rate a constant it

Â can easily be shown that the earnings growth rate is the same as

Â the dividend growth rate.

Â Now we have the dividend growth rate (g) equals retention rate

Â times return on new investment.

Â A firm can increase its dividend growth rate by returning more of its earnings,

Â but this means it will be able to pay out less as dividends.

Â If a company wants to increase its stock price, should it increase its

Â retention rate and invest more or reduce retention and increase dividend.

Â The answer depends on the profitability of the firm's investment.

Â Let's look at an example to better understand this tradeoff.

Â A firm is expected to have an earnings of $5 next year.

Â Without any growth expectations, it decides to payout of its earnings as

Â dividends and its current stock price is $50.

Â This means that the firm's expected return rE,

Â is the dividend of 50 over its current price,

Â 50 plus the growth of dividend 0, which gives us 10%.

Â Say the company now decides to increase its retention rate to 25% and invest

Â the retained earnings in investments that give a return on investment of 12%.

Â Will this change the company's stock price?

Â If so, in which direction.

Â Growth rate g is now the retention rate of 25% times

Â the return on new investment, 12%, which gives us 3%.

Â The stock price today, P sub 0,

Â would be the reduced dividend of 5 times 1- 0.25

Â / (0.10-0.03), which comes to $53.57.

Â Clearly having a return on new investment of 12% increases the stock's

Â price if the company decides to increase its retention rate.

Â What would happen to the stock if the return on new investment were only 8%?

Â The growth rate g would be 25% times the return on investment,

Â 8% which gives us 2%.

Â The stock price today P sub 0 would be

Â the reduced dividend of 5(1+0.25) /

Â (0.10-0.02) which comes to 46.875.

Â What if the return on new investment were 10%?

Â You can verify that this would not change the stock price.

Â What does this tells us when increasing retention rates will increase

Â stock prices and when it will lead to a decrease in stock prices.

Â If the return on new investments is greater than the discount rate or

Â the expected return on the stock,

Â Increasing retention rate will increase stock prices.

Â On the other hand when the return on new investments is less than the discount

Â rate, increasing retention rate will decrease stock prices.

Â Next time we will look at another way of valuing stocks,

Â namely valuation based on compatible forms.

Â