From: ask@cbnews.cb.att.com (Arthur S. Kamlet)
Subject: Re: Stock terminology questions
Organization: AT&T Bell Laboratories,  Columbus, Ohio
Distribution: usa
Date: Sun, 3 Jan 1993 21:29:53 GMT
Keywords: PE ratio, dividend, long-term implications

In article <1993Jan3.201152.4025@netcom.com> hcb@netcom.com (H. C. Bowman) writes:
>Let's say that company XYZ trades at $10.  Let's also say that its
>PE ratio at this price is 10, and that its yearly dividend is $1. 
>If I understand the significance of the PE ratio and the yearly
>dividend, I conclude from this information that the company's profits
>are passed on more-or-less completely to its shareholders.

The simple answer is yes.

The more complicated answer is to look at cash flow.

"Earnings" is a term, a figure you can calculate.  Many things can
effect earnings which don't necessarily affect the cash flow or the
health of the company.

Let's say Wigits, Inc manufactures and sells wigits.  

If it decides some of its manufacturing equipment is obsolete and
hasn't been used for a few months and will never really be used,
it might decide to write off the undepreciated balance and take that
charge against current earnings.   Earnings will go down but cash
flow might not be affected by the decision to write down this
equipment. Its balance sheet might show lower debt and lower assets.

So a decrease in earnings does not necessarily mean the company is
any less healthy.

>Now let's say that company XYZ still has the same share price and 
>PE ratio, but the dividend is now only $0.75.  I conclude from this
>information that the company is using 1/4th of its profits for...
>well, something.  (capital to expand, pay off debts, etc.?)  Unless
>I'm eager for maximum current income, I suppose I should view this
>as a *good thing*, shouldn't I?

The simple answer is again, yes.

What the company is doing is saying to shareholders:  We think we
can do better for you by retaining some of our earnings than by 
paying them out in dividends.

If the company is earning 9% on its shareholder equity, and it
retains some of its earnings, it will have now increased its equity
- all things being equal.    It makes a commitment to shareholders
that it will continue to earn at least 9% on both old equity and new
equity due to retained earnings.  Shareholders should expect it to
earn that much.  If expectations fall, the stock price might fall
too.

>Now, finally, let's say that the same company XYZ with the same
>share price and same PE ratio is forking over $1.25 per year
>in dividends.  I take this to mean that the company is paying share-
>holders something more than its  profits, and that the extra $0.25
>is coming from increased debts, operating capital, etc.  Unless
>I want to collect my dividend and get out quickly, I suppose I should
>view this as a *bad thing* in general, shouldn't I?  

The simple answer doesn't usually work here.

Again, look at cash flow and expected long term earnings.

There could have been some extraordinary charge taken against
earnings but if the company elects to pay its current dividend,
that's often a sign of confidence.

Two years ago AT&T took an enormous 4th quarter charge to account
for reorganization expenses, so much so that it had negative
earnings for that quarter!  But it continued to pay its dividend,
and today the stock is at an all-time high.

However if a company is in real trouble, like GM was and might still
be, it will cut its dividend as a signal for shareholders to lower
their earnings expectations.  If it keeps its dividend while
earnings fall below that level, it should be sending a message of
confidence.

Some companies are strongly cyclical, and in some quarters it
normally has earnings below its dividend, but more than makes that
back in the good quarters.

Finally, the level of dividend is often industry dependent.
Food chains and restaurants, for example, will often have no or
very small dividends, while utilities will often have high
dividends.   Years ago the auto industry would have above average
dividends, and would often have an extra dividend at year end.
Those were the old days.
-- 
Art Kamlet  a_s_kamlet@att.com  AT&T Bell Laboratories, Columbus
Newsgroups: misc.invest