P/E Ratio Correlation to Payout Ratio

[800peace]

I'm reading an article in Harvard Business Review called "Investing in a dividend boost." In the article there's a chart showing a relationship between the P/E Ratio of a company with its Dividend Payout Ratio. The higher the payout ratio, the higher the p/e ratio. The lower the payout ratio, the lower the p/e ratio.

Using the linear line of best fit on a scatter-graph of S&P 500 companies' payout-to-price/earnings, I discovered the following formula:

Price-to-Earnings = 0.4933*Payout Ratio + 9.472. Any company falling below this line would be considered under-priced, and any company falling above this line would be considered over-priced.

For example, GSk has a payout ratio of 38.45, which implies a fair P/E ratio of 0.4933*38.45+9.472 = 28.44. Given GSK actual P/E ratio of 7.09, GSK should be considered undervalued.

[benjamen]

1) Do you have a link to this article?
2) Can you show us the graph?
3) For the stat nerds, do you have the ANOVA table of your linear regression?

[800peace]

I've attached the article and my work on the S&P 500.

[benjamen]

Warning, statistics ahead...

Running a regression in excel's Data Analysis toolpack, I can replicate your regression equation plus output an ANOVA table to get a better idea of this relationship.

Using your exact set up, I get:
R square = 0.1779 (not very predictive)
Significance F = very low (this is good)
p-value for the payout ratio variable = very low (this is good)
p-value of the intercept variable = 0.053 (this fails the 0.05 threshold)

Since the intercept has a high p-value, I reran the regression using no intercept. I actually got better results with the y = 0.54085*x equation.
R square = 0.2559 (not great, but better)
Significance F = very low (this is good)
p-value for the payout ratio variable = very low (this is good)

Wrap up:
Even with the improved equation, the predictive value of the payout ratio isn't that strong. These two ratios are most likely loosely correlated, with no causation. Use with caution.

[EricL]

Watching payout ratios is good in a general sense, but different companies in different industries can have different ratios with varying levels of safety. For instance a utility, consumer staple or REIT can comfortably carry a 60-80% payout ratio while a materials, energy, tech, or discretionary company will have a tougher time keeping that high of a ratio.

Each company needs to be looked at individually based on historical numbers, consistency of earnings, debt loads, cyclicality, etc.

I don't think a single formula can be generated to give useful results because of this.

[800peace]

I back-tested the formula and achieved alpha, however dividend growth was pitiful.

Looking at the stats provided by Ben, it reminds me that association is not causation. Just because high p/e ratios are associated with high payouts, doesn't mean high payouts cause high p/e ratios.

On a side note... I'm really glad I found this forum. Thanks for your replies!

[EricL]

Here is an article I wrote that talked a bit on payout ratios.

I made up this table to show the payout ratios in a easier to digest form, although it could probably use a "10" value for PE on there now that I look at it again.



In my opinion payout ratio in itself doesn't tell much of a story without taking into account growth rates, valuation, business type, etc. It is a piece of the puzzle, but I have my doubts if it could be used as any sort of forecasting tool by itself.

[800peace]

I totally agree that the payout ratio can lead due-diligence astray. I actually created a thread called "My Beef w/ Payout." I did find the association between p/e and payout interesting and had to hypothesize and experiment. It wasn't the pot of gold I was hoping, but it is helping me tackle the energy and financial sectors, (I find these sectors hard to analyze).

[EricL]

(06-01-2015, 04:13 PM)800peace Wrote: I totally agree that the payout ratio can lead due-diligence astray. I actually created a thread called "My Beef w/ Payout." I did find the association between p/e and payout interesting and had to hypothesize and experiment. It wasn't the pot of gold I was hoping, but it is helping me tackle the energy and financial sectors, (I find these sectors hard to analyze).

You aren't alone. Energy is difficult due to the cyclical nature. I'd recommend focusing on high credit ratings and good long term track records in the energy sector. It takes a strong stomach to hold during the downturns like we are currently experiencing, but if you are able to add on pullbacks and focus on quality, the reinvestment of dividends are a nice bonus when prices rise once again.

I also don't own much for financials either due to difficulty in valuing them. The only bank in my personal portfolio is Wells Fargo (WFC) and I also have some Ameriprise Financial (AMP), which is an insurance/asset management company.

[800peace]

(06-01-2015, 02:27 PM)EricL Wrote: Here is an article I wrote that talked a bit on payout ratios.

I made up this table to show the payout ratios in a easier to digest form, although it could probably use a "10" value for PE on there now that I look at it again.



In my opinion payout ratio in itself doesn't tell much of a story without taking into account growth rates, valuation, business type, etc. It is a piece of the puzzle, but I have my doubts if it could be used as any sort of forecasting tool by itself.

(06-01-2015, 04:32 PM)EricL Wrote:

(06-01-2015, 04:13 PM)800peace Wrote: I totally agree that the payout ratio can lead due-diligence astray. I actually created a thread called "My Beef w/ Payout." I did find the association between p/e and payout interesting and had to hypothesize and experiment. It wasn't the pot of gold I was hoping, but it is helping me tackle the energy and financial sectors, (I find these sectors hard to analyze).

You aren't alone. Energy is difficult due to the cyclical nature. I'd recommend focusing on high credit ratings and good long term track records in the energy sector. It takes a strong stomach to hold during the downturns like we are currently experiencing, but if you are able to add on pullbacks and focus on quality, the reinvestment of dividends are a nice bonus when prices rise once again.

I also don't own much for financials either due to difficulty in valuing them. The only bank in my personal portfolio is Wells Fargo (WFC) and I also have some Ameriprise Financial (AMP), which is an insurance/asset management company.

I've noticed energies and financials can be a little too boom and bust. Plus a lot of the ratios and financial statement numbers I rely upon are all over the map... I almost think you have to be an insider to know what the heck happened in a energy or financial business.