Question

How do companies set dividend targets?

What is the connection to EPS?

Answer 1

Setting of Dividend Targets by Companies

• The Target Payout Ratio, or Dividend Payout Ratio, is the fraction of net income a firm pays to its stockholders in dividends. It is calculated by dividing the dividends distributed by the net income for the same period. The part of the earnings not paid to investors in the form of a dividend is left for investment to provide for future earnings growth. Investors seeking high current income and limited capital growth prefer companies with high Dividend Payout Ratios.
• The Target Payout Ratio depends on what investors the management of a company are trying to attract, and what current investors’ expectations are. It also depends on the growth goals of the company. If a company is trying to grow very fast, it may prefer to reinvest its income in expanding operations.
• The residual-dividend model is a model that a company can utilize to set a target dividend payout ratio. This model is based on An investment opportunity schedule, Target capital structure and Cost of external capital.
  • The first step in the residual dividend model to set a target dividend payout ratio to determine the optimal capital budget.
  • Then, management must determine the equity amount needed to finance the optimal capital budget. This should be done primarily through retained earnings.
  • The dividends then are paid out with the leftover, or residual, earnings. Given the use of residual earnings, the model is known as the "residual-dividend model".

Connection to EPS

• The relationship between EPS and DPS isn‟t a straight line relationship as the percentage of earnings paid off to the shareholders as dividends isn‟t definite and fixed.
• EPS had a positive and significant effect on DPS while leverage, liquidity, and retained earnings had negative but insignificant effects on DPS.
• Investors and analysts who are interested in investing in firms that can pay higher dividends should use the EPS as a basis for forecasting the DPS of the firms in which they seek to invest or advise their clients on where to invest.