SHARES

Earnings growth outpacing dividends growth

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In theory dividends should always be paid out of profits. It is how companies pass back some of their success to their shareholders. Companies must choose how much of their profits to pay out as dividends and how much to keep to reinvest in the business. This is known as the payout ratio.

Companies that believe they can generate high returns on the profits they reinvest should keep a high proportion of those profits so they can generate greater wealth for their shareholders in the long term. The company grows through their successful reinvestment, driving up the value of the business and therefore the share price.

In Australia there is more pressure on companies to pay higher dividends due to the reliance of many investors on the income stream and also the favourable tax regime (franking credits).

dividends

If dividend growth is outpacing earnings growth it means that an increasing proportion of profits is being paid out as dividends rather than reinvested. Whilst this may be beneficial in the short term, in the long term it is detrimental as companies will be restricted in their future growth which will constrain their value and share price growth. Ultimately it flows through to the economy as less investment will mean less growth.

Banks are now holding their dividends constant rather than increasing them. A major factor in this is tougher regulatory requirements that require banks to hold more capital. All the major banks had to raise equity capital last year. As they pay out dividends they are simply giving some of it back. The easiest way for banks to increase their capital is to hold onto a greater portion of their profits.

Mining stocks have also slashed their dividend payouts. As commodity prices have plunged, so too have mining company revenues. As costs are relatively fixed, profits have to fall. It is not rational for companies to pay dividends that exceed their profits. The only way to do that is by running down cash reserves, raising debt, or raising equity (take with one hand and give back with the other). RIO and BHP have faced reality and dumped their progressive dividend policies.

Earnings growth outpacing dividends growth means that companies are bolstering their own capital to ensure they have the funds to invest in the future and ride out any storms. This should benefit companies and their shareholders in the long term and also be positive for the economy.

In the short term some investors may suffer as their dividend income stream is reduced, but in the long term the companies they own will be more robust and in a better position to pay dividends in the future.

Dividends table
As at Feb, 25, 2016

Chris Batchelor CFA, Skaffold

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