Reading 33 p.169. The reading gives the formula for the expected increase in dividends as increase in earnings x target payout ratio x adjustment factor. There is then an example where if earnings increase by $0.50 to $1.50, the target payout ratio is 50% and the adjustment factor is 0.2 then there will be a $0.05 increase in dividends to $0.45. The article goes on to note that if the following year earnings fell from $1.50 to $1.00 then the dividend may well increase by up to $0.05. ?? Hang on, if earnings fall then the formula suggests that the change in dividend will be negative (or I guess no change since it would be a bad signal if the dividend were to fall). What if earnings instead were forecast to remain at $1.50? There would be a $0.00 change in EPS and therefore the expected increase using the formula would be nil even though the current payout ratio is well below the target ratio. It seems to me that the formula does a pretty bad job at moving the dividend closer to the target ratio. Surely a better formula would be: (earnings * target payout ratio - last dividend) * adjustment factor. Thoughts?
Zero replies to this query after 4 years ? And other posts on the topic also not answering this point ?? Disappointing.
lol, wonder of he/she passed and now has his/her Charter
You make a good point but the formula is fine. There may even be years when the estimated dividend is actually further from the target. The point is about the long run; the formula holds in the long-run and the dividend moves closer to the target payout. Don’t lose sleep over the year to year changes, even if they seem to contradict the purpose.
They pay the increase throughout 5 years. I suppose that the change in year 2 is going to be payed through years 2-6 and so on… like a smoothed time series, that’s why they say that it is a simplified version of the model.
My interpretation (assuming that the adjustment factor takes place during 5 years):
Expected increase in dividend in year 1 = alpha = Increase in earnings1vs0 × Target payout ratio × Adjustment factor
Expected increase in dividend in year 2 = beta = alpha + (Increase in earnings2vs1 × Target payout ratio × Adjustment factor)
Expected increase in dividend in year 3 = alpha + beta + (Increase in earnings3vs2 × Target payout ratio × Adjustment factor)
…
Expected increase in dividend in year 6 = phi = Increases arising from years 2-5 (say beta+gama+vega+rho…) + Increase in earnings6vs5 x Target payout ratio x Adjustment factor)
The original model also assumes that there is an error factor and the equation is more complicated than this one… but the idea is that companies tend to maintain a stable dividiend dollars and they try not to reduce it in nominal value, in order to achieve that objetive companies tend to be conservative and amortize slowly the dividend, however if there is an extreme reduction in earnings the smoothing is less effective.