P/E and dividend growth rate with 100% payout

annasmom

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I ran across a question in Schweser about the equation for P/E when a company pays out 100% of earnings as dividends. I understand that P/E= dividend yield/(k-g). So with a dividend yield of 100%, the equation simplifies to P/E= 1/(k-g). But the correct answer is P/E= 1/k because g=0. I must be missing something, but why does the growth rate of dividends have to be zero when the payout ratio is 100%? Can't dividends continue to grow in this situation?
 
annasmom, you're correct that with zero growth the Gordon Growth Model simplifies to the value of a perpetuity, and that this theory is almost certainly an over-simplification of what could transpire in reality. Nonetheless, here's my understanding of the theory:

If a firm is paying 100% of its dividends to shareholders, it's foregoing the opportunity to invest in positive-NPV projects, acquisitions, or other transactions that could increase the firm's size and eventually translate into growing dividends. Bottom line: barring some sort of intervention, this firm and its dividends aren't going to grow.

Moreover, what sort of firm would have such a high payout ratio? Almost certainly it's a large, profitable firm in a mature industry that frankly isn't faced with many positive-NPV investment opportunities in its core operating areas. Perhaps it could grow by acquiring market share (other firms). I think it's what the BCG Growth-Share Matrix would call a "cash cow."

When you study Dividend Policy, you'll see that a 100% payout ratio probably isn't a great idea because investors seem to favor predictable payments.

You'll also encounter the equation: g = RR * ROE
A firm's sustainable growth rate is its earnings retention rate (in this case zero) * its ROE. I think this assumes no new equity is issued, among other things, but someone like JoeyDVivre who's stronger in mathematics and these theories than I will have to chime in.

In any case, I hope that helps. Just keep in mind that much of the theory you're learning is conceptually accurate, interesting, but doesn't necessarily hold in reality. It's good to see that you understand the Gordon Growth Model, because you'll be using several variations of it when you reach Level II.

Good luck!



Edited 1 time(s). Last edit at Saturday, July 21, 2007 at 01:41PM by hiredguns1.
 
hiredguns1 Wrote:
-------------------------------------------------------
> annasmom, you're correct that with zero growth the
> Gordon Growth Model simplifies to the value of a
> perpetuity, and that this theory is almost
> certainly an over-simplification of what could
> transpire in reality. Nonetheless, here's my
> understanding of the theory:
>
> If a firm is paying 100% of its dividends to
> shareholders, it's foregoing the opportunity to
> invest in positive-NPV projects, acquisitions, or
> other transactions that could increase the firm's
> size and eventually translate into growing
> dividends. Bottom line: barring some sort of
> intervention, this firm and its dividends aren't
> going to grow.
> ..

what if the compan yis generating all this income from increasing debt?. dividends can still grow theoretically
 
Thank you, hiredguns 1. I really appreciate the explanation. I'm finding much of the material difficult, but I guess that's not surprising, since I'm coming to it with no formal finance background. But it's really good to know that there are smart people on this forum who can help!
 
Dsylexic, to your point, I thought about addressing that further in my initial post, but really it's the domain of corporate finance rather than asset valuation.

I think the Pecking-Order Theory of capital trumps here. Specifically, faced with profitable investment opportunities, a firm will choose to fund the projects using lower-cost sources of capital and only resort to higher-cost capital after the former is exhausted.

The order from lowest-cost to highest-cost is: retained earnings, debt, equity.

Keep in mind that this firm will seek to minimize its WACC, which also maximizes firm value.

Therefore, I think we can safely assume this firm isn't investing in any positive NPV projects b/c it's not even making use of its lowest-cost capital (i.e. retained earnings).

Moreover, at Level II you'll deal more with the concept of sustainability (particularly w/r/t to cash flows), and it'll become apparent that firms cannot issue debt or new equity indefinitely. These are not sustainable sources of capital by which the firm can continue to grow. It'll either become insolvent (i.e. by issuing excessive debt) or its share price will approach zero as increasing amounts of equity are issued. Another persnickety detail: I'd wager the indenture of any new debt issue would explicitly forbid the proceeds from being used to pay dividends (i.e. a negative covenant).

annasmom, to your point. I'm not a smart person, I just play one on TV! Keep up the studies, it'll make more sense soon.

Cheers.
http://en.wikipedia.org/wiki/Pecking_order



Edited 2 time(s). Last edit at Saturday, July 21, 2007 at 03:18PM by hiredguns1.
 
hiredguns1, your explanations are impressive.
Appreciate your effort here. Please keep up the good work!
 
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