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## Payout Ratio

The payout ratio $f$ is the elephant in the room, and there are key assumptions that are made in valuation models that are not discussed often enough, because the assumptions to be made are heroic.

### Payout Through Dividend

The dividend policy of a company tends to be stable through time while earnings fluctuate. We have long term data at the SP500 index level since 1870 thanks to Schiller. To smooth out the ratio, I use the ratio of 5-year average of dividends and earnings. This shows a payout ratio $f$ that was above 70% and went down to 40%.

In a world where analysts are obsessed with quarterly numbers, we can see that earnings are too volatile, and even smoothing payoff ratio over a 5Y or 10Y cycle does not tame the volatility, although it stretches the reactivity of the indicator.

### Dividend and Tax

The payout ratio reduced over the century. Income tax was introduced and raised. This made dividends a very inefficient form of distribution to the stockholder, which good management may avoid. Arguably, the fundamental value of a stock is the after tax dividend. The value of a dividend needs to be further haircut by the top income tax bracket that the investor is scheduled to be paying over his remaining holding period.

For foreign investors in US and Australian stock with no tax treaty, the dividends are worth 70%. WHT information can be found on this pwc site. For Hong Kong residents:

• UK 0 WHT
• IT, FR, SP, NETH, JP 10% WHT
• CAN: 15%
• GER: 25%
• AUS, US 30%

Arguably, there are two payout ratios: one that compute the fundamental value of the stock to one's tax situation through holding it, and another one for the average market participant, in which case he is computing a fair average market value.

### When Payout Ratio Increase

The other question is what happens for growth companies that don't pay a dividend. Is the value of Amazon, Tesla and Google 0 because they do not currently pay a dividend?

We had an answer to this 10 years ago, as companies such as Apple and Microsoft that had never paid a dividend for their first 25 years and compounded handsomely during that period eventually started paying dividends.

Arguably, the payout ratio $f$ can increase as the company matures and becomes a cash cow. Typically, a company with a 0 to 40% payout ratio may increase it gradually to 80% if the management is so inclined.

The other possibility is for the company to buyback its stocks. This enables the company to reduce the number of shares and therefore increase its earning per shares. If this is done at constant earning yield, price is increasing and money is being returned to shareholders who are subject to lower capital gains tax rates instead of dividend income tax rates.

Such activity does show up as share buyback on the cashflow statement but it can be mingled with a more extractive practice by the company officers of awarding themselves stock options whose value is not properly declared in the GAAP accounts.

For this reason, we just observe the amount of diluted shares declared by the company and count the dilution as an improvement or a deadweight on earning yield, and adjustment on payout ratio.

### Quality of Earnings

Some still consider dividends to be more reliable measures of value than earnings

• earnings may legally not include the effect of stock option awards in the company reports
• earnings may legally include paper gains on pension plans
• ordinary losses may be categorized as extraordinary items on bad years to boost the results on normal years
• the earnings declared for tax purpose and their reconciliation to GAAP are not shown on the accounts
• earnings may include so many non-cash items, such as intangible and depreciation manipulations, as to make it unclear whether interest coverage and sufficient cash for future investment is available besides earning.

For instance, what Buffet deems to be earning is actually free earnings available to be distributed to the owner.