Dividend: The money which is paid out to the shareholders from the net profit of a business can be termed as a dividend. Distribution of dividend can be termed as the reward to the shareholders of the company at regular intervals subject to the profitability of the business. Investors do give emphasis on the dividend amount distributed by the company.
Price to Earnings ratio: Price to earnings (P/E) ratio determines the multiplier of the company’s earnings per share that investors are willing to pay for the company’s one share. The price to earnings multiple increases when the investor community predicts that the particular business will deliver superior earnings growth in coming years. Thus, a stock quoting at $10 with an EPS of $1 denotes the P/E of 10X ($10/$1). The formulae of Price to earnings is determined by Current stock price/ Earnings per share.
1) Mode of evaluation: Investors do evaluate a company on the basis numerous fundamental factors like products of the company, market share of the products, management history, sectoral approach, thematic approaches, profit growth of the company, major acquisitions etc. However, in recent years investors have started valuing stock based on dividend history and price to earnings multiple. The common thing between them is that both the approaches are based on the correlation with the earnings of the company. When the earnings of the company increase, the company can opt for higher dividend payout ratio. Dividend payout ratio determines the relationship between the total dividend distributed and the total earnings generated by the company. The formulae of dividend payout ratio can be written as, Dividend payout ratio = Total dividend distributed / Net Earnings.
The dividend payout ratio is expressed in terms of percentage and calculated as a proportion of earnings. The payout ratio talks about a number of things such as the nature of the business, the future plans and many more. A company which is growing at an exponential rate may not opt for dividend payout to its shareholders. The company might have future expansion plans and want to retain funds for the same. The management might have decided to retain the company’s profits and utilize the same for future expansion plans instead of taking loans from the market. A borrowing will finally lead to reduction in the profits as the company has to pay interest costs which will be added to the total expense of the company. A mature company with a sustainable business model might not be requiring capex funding as the infrastructure of the company is already established. Thus, these mature companies may opt for dividend payout from their earnings.
For example, Afterpay Touch Group Limited (ASX: APT) can be classified as a growth company. During FY19, the company has delivered a pro-forma net transaction margin growth of 126% over FY18 and yet the company has not distributed dividends to the shareholders. The company in its early stages of expansion and needs capital to build out its infrastructure. The company has a market capitalization of $8.03 billion. Let’s talk about a matured company with good market share and stable profitability. We can take the example of Westpac Banking Corporation (ASX: WBC) where the market capitalization stands at $103.51 billion. The company reported 24% lower profits during H1FY19 on y-o-y basis and still a dividend of 94 cents per share was declared in recent past. The annualized dividend yield of the company stood at 6.34%. WBC is one of the prominent banks across Australia and New Zealand and have a decent amount of market share. The business does not have an immediate requirement of capital expenditure and the management decided to distribute a part of earnings among the shareholders. Thus, it can be inferred that the maturity plays one of the pivotal roles in determining the dividends of a company.
Coming back to Price to earnings multiples, investors’ expectations tend to change regularly. It depends upon several macro factors like, central bank’s interest rate, credit growth of the sector, liquidity scenario in the economy, earnings growth of index stocks, consumer sentiment, bear market or bull market scenario etc. In case of a bear market scenario, the sentiments of the investors remain weak and in most of the cases they are willing to pay a lower multiple for the stocks they tend to purchase. Thus, despite of stellar earnings growth, the investors will refuse to pay higher multiples for those stocks. Whereas, during bull market, the sentiment remains high and investors, in most of the cases, are ready to pay higher P/E multiples for the stocks.
2) Investor’s expectations: Another factor which shapes up the price to earnings ratio is the investors’ expectations from a certain company. Two companies delivering stable earnings over several years might have different P/E multiples because of different future earnings expectations from the two. The higher the expected earnings, Investors are ready to pay higher amount for the stock and it is determined in terms of Price to earnings ratio. For example Sonic Healthcare Limited (ASX : SHL) has a P/E earnings ratio of 22.740X. The company has delivered a yearly net profit growth of 16% on y-o-y basis in FY 2019. While the net profit of WBC during H1FY19, decrease by 24% on y-o-y terms and the current P/E multiple of the company stands at 14.390X. This suggests that investors are more bullish on SHL compared to WBC, SHL’s market capitalization being $13.23 billion compared to $103.51 billion of WBC. The convictions of the investors regarding the future earnings for SHL is way higher than that for WBC. Thus, the investors are ready to pay a higher multiple in case of SHL.
There are a group of investors who invest in stocks for 15-25 years as they tend to believe on the business prospects of the company and believe that the company will generate profits for long-term. Most of these businesses follow the similar models. For example, ace investor Mr. Warren Buffet continued to hold stocks like Coca-Cola, Gillette etc for 20-30 years as he is bullish on those companies. These types of investors hold major stakes in the company and use the dividend to buy more shares of the company. Thus, the dividend received by the investors are utilized for investing in the equity of the same business. The market prices of stocks tend to vary. In most of the cases a good company with robust business model will deliver constant earnings growth and the share price of the company will likely rise in a span of 5-10 years. Thus, the investors would get lesser number of shares if he chooses to reinvest his dividend amount into purchasing shares of the company.
3) Movement of stock prices: The P/E multiple and the dividend yields are inversely corelated with each other. If a stock moves up drastically, the price to earnings ratio would tend to increase for a while. But the dividend amount will stay at the same levels, and so will its EPS. Thus, the P/E multiple will jump, and the dividend yield will sink. In case of the dividend yield, the dividend announced will be measured on the basis of current market price of the stock and higher the price lower would be the dividend yield. For example, Resmed Inc (ASX: RMD) has delivered earnings growth of 28.2% on y-o-y basis during FY19. The current P/E ratio of the stock stands at 48.350x and the dividend yield of the stock stands at 0.77%. The stock price tends to move with the expectations of future earnings growth of a particular company. A small cap company growing at 10% and a large cap company with 10% earnings growth is expected to have different stock price movements. A large cap company with a matured business growing at a double digit will have higher impact on the stock price compared to the small cap one. A small business with new products will grow at a rapid pace, provided that there is a room for expansion i.e. the product acceptability among the customers’ needs to high. Thus, the investors might not pay higher P/E multiples for a small cap company.
4)Industry-wide classification: Different industries have different Price to Earnings ratios and in most of the cases, the top companies within the sector have more or less relatively the same P/E. The dividend yields may not be correlated amongst the companies within the same sector. The dividend is determined by the board of directors in line with business performance and business requirements and has no relation with the stock price. For example, companies operating in the healthcare software segment have different yields. Companies like SHL and RMD have a dividend yield of 3.02% and 0.77%, respectively. While companies like WBC, MQG and NAB which operate in the banking industry have yields of 6.34%, 4.47% and 6.28%, respectively.
Dividend history of SHL (Source: Company Reports)
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