Reading 21 in CFAI text, Question 11 states companies with low growth prospects are least likely to have low dividend payout ratios. So I’m guessing this implies companies with high growth prospects are likely to have low dividend payout ratios. What is the reasoning behind this?
Low growth prospects means fewer good places to re-invest earnings so the company will typically distribute them to shareholders. High growth prospects means the company has many good opportunities to re-invest their earnings.
Got it, thanks. Although I wonder if a company didn’t have good growth prospects wouldn’t it hold onto its earnings in case of a rainy day and thereby not increase its dividends? Or is it more important to keep the shareholders happy? In which case wouldn’t keeping the dividend payout ratio at it’s current levels be a smart move?
Furthermore, question 33 in the same reading says that the implementation of a regular cash dividend based on a residual dividend policy is a sign of the company signalling to shareholders that earnings growth is expected to increase. Isn’t this contradictory to “low growth prospects means fewer good places to re-invest earnings so the company will typically distribute them to shareholders”?
It is a bit contradictory but the key here is the reference to earnings growth, not revenue growth. Revenue growth generally requires additional capital to expand. Earnings growth by itself does not necessarily require additional capital (ex. reinvested profits) to realize. For example, if oil prices double, an E&P oil company might institute or increase a dividend.