I am having difficulties with this question from Investopedia:
Which of the following statements is (are) true when interpreting ratios that represent the company’s growth potential? I. A company’s growth rate will increase as its dividend payout ratio decreases. II. The higher the level of preferred dividends, the higher the payout ratio to common equity holders. III. The retention ratio is the inverse of the dividend payout ratio. IV. The payout ratio can never be as high as the retention ratio. A) I and II only B) IV only C) III and IV only
The correct answer is a).
I don’t really see why II is correct. Why should the amount of preferred dividends affect the payout ratio to common equity holders. As far as I understand, the dividends for preferred shares are “set it in stone”, that is as long as the company is doing well, the preferred dividends are constant (say $8 and par value of $100, so 8%). They are not increased upwards if the company did particularly well that year, so I do not see why their level should affec the common dividends.
Think of it this way. Say you are paying out $100 dividends on $1000 income with no preferred dividends. That’s a 10% payout ratio (the rest is being reinvested). Now imagine, you are paying the other $900 to preferred dividends. Your payout ratio is now 100% and you are are not reivesting anything back into the company. So your growth rate will be lower.
Thank you so much S2000 for the quick response. Given that defition of the payout ratio, the whole thing makes sense.
However, I struggled a bit to find this definition of the payout ratio in the CFA books. On Investopedia I found two alternative versions of it:
“…The payout ratio is commonly calculated in one of two ways, either on a total basis, in which case the ratio is calculated by dividing the total amount of dividends paid out by the company’s total net income, or on a per share basis where the formula used is dividends per share divided by earnings per share, or EPS. EPS represents net income minus preferred stock dividends divided by the average number of outstanding shares over a given time period…”
If I argued along the lines of the first definition, i.e. total dividends over total net income, there would not be a relation between preferred dividends and common dividends, right?
@JSD: Thank you so much for your explanation, however my question was regarding no II, sorry, I did not make that quite clear. Intuitive explanation in any case though!!