Growth Stocks and Income Stocks

We often hear investors speak of growth stocks and income stocks. They seem to buy growth stocks primarily in the expectation of capital gains, and they are interested in the future growth of earnings rather than in next year's dividends. On the other hand, they

Suppose that another stock market analyst predicts that United Bird Seed will not settle down to a constant 5 percent growth rate in dividends until after Year 4, and that dividends in Year 4 will be $1.73 per share. What is the fair price for the stock according to this analyst?

PAYOUT RATIO Fraction of earnings paid out as dividends.

PLOWBACK RATIO

Fraction of earnings retained by the firm.

TABLE 3.6

buy income stocks principally for the cash dividends. Let us see whether these distinctions make sense.

Think back once more to Blue Skies. It is expected to pay a dividend next year of $3 (DIV1 — 3), and this dividend is expected to grow at a steady rate of 8 percent a year (g — .08). If investors require a return of 12 percent (r — .12), then the price of Blue Skies should be DIV1/(r - g) — $3/(.12 - .08) — $75.

Suppose that Blue Skies's existing assets generate earnings per share of $5.00. It pays out 60 percent of these earnings as a dividend. This payout ratio results in a dividend of .60 x $5.00 — $3.00. The remaining 40 percent of earnings, the plowback ratio, is retained by the firm and plowed back into new plant and equipment. (The plowback ratio is also called the earnings retention ratio.) On this new equity investment Blue Skies earns a return of 20 percent.

If all of these earnings were plowed back into the firm, Blue Skies would grow at 20 percent per year. Because a portion of earnings is not reinvested in the firm, the growth rate will be less than 20 percent. The higher the fraction of earnings plowed back into the company, the higher the growth rate. So assets, earnings, and dividends all grow by

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