Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 11 Stockholders’ Equity: Capital Stock and Dividends 511

As can be seen, the dividend yield varies widely across firms. Which dividend
yield is right for an investor? The answer depends on the investor’s objectives. The div-
idend yield on common stock is of special interest to investors whose main objective
is to receive a current dividend return on their investment. In addition, a stock with a
healthy dividend yield should be less likely to decline significantly in market price,
because the increasing yield would attract buyers. However, a high dividend yield
also restricts a company’s growth because cash is used for dividends rather than for
business objectives. Investors must also be careful in purchasing common stock with
very high dividend yields, such as with General Motors. Such high dividends may be
“too good to be true.” The high dividend yield may not be safe, meaning that financial
difficulties may force management to reduce the dividend in the future.
In contrast, investors whose main objective is a rapid increase in the market price
of their investments may not desire a high dividend yield. For example, growth com-
panies often do not pay dividends, but instead, reinvest their earnings in research and
development, such as with Oracle Corporation. Investors expect such stocks to in-
crease in market price as a result of this reinvestment. Since many factors affect stock
prices, an investment tactic relying solely on increases in market prices is more risky
than a tactic based on dividend yields.

Dividend Payout Ratio

Investors purchasing common stock for their dividends need to assess the likelihood
that the existing dividend can be maintained, which is termed dividend safety. While
evaluating the safety of the dividend involves many considerations, one important
measure is the amount of the dividend as a percent of net income. The dividend pay-
out ratiois the ratio of the cash dividend to the net income of the company, deter-
mined as follows:

Dividend Payout Ratio 

Annual Cash Dividends



Annual Cash Dividend per Share

Annual Net Income Annual Earnings per Share

To illustrate, Mattel, Inc., recently reported earnings of $537.6 million and paid
cash dividends of $171.3 million. The dividend payout ratio would be as follows:

$171.3

31.9%

$537.6

This ratio means that Mattel paid out more than 30 percent of its annual earnings
in dividends. This is a reasonable payout ratio that would be considered maintainable.
In contrast, General Motors is paying dividends in the midst of losses, which might
not be considered sustainable in the long term.
Exhibit 8 shows the dividend payout ratios for a number of different industries.
As can be seen, the dividend policies are not consistent across industries. Indeed, some
industries, such as telecommunications, are paying out more in dividends than they
are earning. They cannot sustain this payout ratio in the long term. As of this writing,
some telecommunication companies are experiencing low profitability, while divi-
dends have yet to be cut to reflect this reality. In contrast, software and consumer elec-
tronics industries have very small payout ratios, which reflect their high internal
growth prospects. That is, management from these industries choose to retain earnings
for financing growth, rather than pay them out as dividends.

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