To help students learn the underlying factor that determines the relationship between retention ratio and current stock price.
Relationship between Retention ratio and Current Stock Price
View 1: It is commonly believed in finance literature that such firms which pay all of their earnings in the form of dividend to its shareholders have lower current stock price than those which retain portion of earnings to reinvest in the profitable opportunities available in the business. Although, retaining portion of earnings means less dividend to be distributed among shareholders, but it gives positive signal to shareholders that their invested money is best utilized by the business as reflected by higher current share price. Thus, their return will be maximized by earning higher capital gain on shares owned.
View 2: There is an opposite view that higher dividend payout ratio is inevitable as paying less dividend can drive down the share prices. Higher dividend income gives positive signal to shareholders as they perceive higher share price in a market that ultimately push the stock prices to move upward.
Following table shows the expected dividend stream and retention ratios of companies named as A, B, C, D and E for a next year. Each company has same expected earnings per share i.e. Rs. 10 per share but their dividend payout ratios or retention ratio vary. The companies and their shareholders expect similar required rate of return on their investments which is 15%.
You are required to identify and explain the relationship between retention ratio and dividend growth rate by calculating the required values in above table. Provide logical reasoning to support your answer.
By examining the impact of retention ratio on current stock price of each company, do you agree with one of the views explained above or not? Provide logical reasoning in either case to support your answer.