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promise to maintain or increase its dividends. Thus, a company that pays a $ 2 dividend this
year can reduce the dividend or even eliminate it if it so chooses. While investors may view
this action with disappointment and sell the stock (causing the price to drop), they cannot
force the company to pay dividends.
What are the implications for investors? A stock with a high dividend may be an
attractive investment but only if the dividends can be sustained. How do you know whether
dividends are sustainable? There are three approaches. The first and simplest one compares
dividends to earnings in the most recent period to see if too much is being paid out. The
second approach modifies the first one to allow for the fact that earnings are volatile. It
compares dividends paid to normalized or average earnings over time to make the same
judgment. The third approach tries to measure how much the company could have paid in
dividends, allowing for the reality that companies often cannot pay out their entire earnings
in dividends when they have to reinvest to grow.
Comparisons to Actual or Normalized Earnings
The first and simpler approach to evaluating the sustainability of divid...
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This note was uploaded on 01/17/2012 for the course ECON 101 taught by Professor Econnorm during the Spring '11 term at Art Institutes Intl. Minnesota.
- Spring '11