If the dividend payout ratio for a stock market series is anticipated to increase as the industry advances towards relative maturity, which of the following would occur assuming that both the required return and expected growth rate remain constant? Further, what would occur if the growth rate of dividends were to exceed the required rate of return?
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A. B. C. D. E.A
Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following:
P/E = [D/E / (k - g)]
Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated growth rate of dividends.
From observing this equation, we can determine what would happen if the dividend payout ratio were to increase. The result is largely intuitive once an understanding of dividend discount methodology is gained. An increase in the dividend payout ratio will lead to an increase in the earnings multiplier assuming that both the required rate of return and the anticipated growth rate are assumed to remain unchanged. In reality, this assumption is nonsensical in this case.
Specifically, the dividend payout ratio is anticipated to increase because the industry is advancing toward relative maturation. In other words, companies comprising the series are expected to pay out more of their earnings as dividends due to diminishing positive NPV investment opportunities. By definition this would decrease the anticipated growth rate, which would in turn lead to a decline in the earnings multiplier.
If the anticipated growth rate were to exceed the required rate of return, the resulting earnings multiplier would be nonsensical. Specifically, the earnings multiplier produced would be a negative number.