Return on Equity Capital, Dividend Payout and Growth of Earnings per Share

Abstract

GROWTH OF per share determines future funds available for reinvestment in corporation and for payment of dividends. It also influences future debt and equity financing, helps set cash income returns to shareholders and partly affects future changes of prices of equity securities. For these reasons accurate estimates of future growth rates of per share are very important to investor, financial analyst, corporate financial manager and student of corporate finance.' One method of estimating future growth of per share is to extrapolate past rates of growth. In an earlier study this approach was found to have little value, at least for comparative purposes. In study of 344 companies in 12 industries in 38 different test periods between years 1950 and 1965, there appeared to be little significant correlation between relative growth of per share in one period and relative growth of per share in next period. Only rarely did companies which recorded superior growth of per share in one period show more than an even chance of recording above average growth in next period.2 A second method of estimating future growth of per share uses rate of return on equity capital and dividend payout ratio. return on equity capital is equal to annual per share divided by equity capital per share. dividend payout ratio is equal to annual dividends per share divided by per share. This method assumes that changes in rate of return on equity capital are negligible. If rate of return remains constant, then growth of per share equals rate of return on equity times proportion of retained. This method of projecting growth rates of per share has been widely advocated from various points of view. Gordon and Shapiro in an analysis of capital budgeting use model which assumes that the dividend will grow at rate which is product of fraction of income retained and rate of return on net worth.3 They assume that rate will be constant and equal to current rate. Lerner and Carleton in their recent A Theory of Financial Analysis use return on investment and payout ratio as key elements of their theory.t In their chapter on projecting Graham, Dodd and Cottle use return on capital and rate of retention as principal method. They note that . as payout rises, this inevitably tends to dampen down increase in per share gains, since smaller percentage is reinvested in business.`> Sauvain uses rate of return and payout ratio as chief indicators of growth of per share in his work on Investment Management6 while Cummin in his article on The Mechanics of Corporate Growth considers a high return on investment and significant proportion of retained earnings keys to superior growth of per share earnings.7 Use of return on equity capital and payout ratios as indicators of future rates of growth of per share is compelling both for its simple logic and for wide range of persons who advocate method. If method is useful for predictive purposes, companies which have had high return on equity capital and/or high rate of retention of in past should tend to achieve superior rates of increase in per share 1. Footnotes appear at end of article.