WisdomTree

Equity

Potential for Dividend Growth Outside the United States

by Jeremy Schwartz, Director of Research on June 20, 2013

The concept of dividend growth is particularly attractive in today’s low-interest-rate environment across developed markets. Time and time again the view is espoused that all the monetary easing being undertaken by developed market central banks will lead to inflation. Rather than investments with fixed payments, dividends are thought to have the potential to grow and even outpace the rate of inflation, should it arise in the future.

While a plethora of options stand out for those focused on U.S. equities, after auditing dividend-focused indexes of international equities outside the U.S., we found the following three options:

• The Dow Jones EPAC Select Dividend Index requires dividend payments for the last three years, in addition to dividend payout ratio and other criteria.
• The NASDAQ International Dividend Achievers Index requires five consecutive years of positive dividend growth. It’s also worth noting that a significant portion of its international exposure is through American Depository Receipts (ADRs) and Global Depository Receipts (GDRs).
• The S&P International Dividend Opportunities Index requires stable or increasing three-year dividend growth in addition to other criteria focused on earnings.

The two major common threads we see across these options:
1. Their weighting schemes focus on dividend yield.
2. Prior to index inclusion, each constituent must demonstrate some history of dividend growth or, at the very least, stable dividend payments.

While these attributes aren’t inherently good or bad in and of themselves, we believe they may not provide the best positioning to generate future dividend growth.

What Determines Future Growth Potential?

Moreover, in the finance literature, return on equity (ROE) is critically linked to dividend growth and intrinsic value of companies through the dividend discount model (DDM).1 The DDM for stock valuation states:
Value of a stock = DPS(1) / (R-G)

Where:
• DPS(1) = Dividends per share expected to be received in one year
• R = The required rate of return for the investment
• G = Growth rate in dividends, which equals ROE x earnings retention (or 1 minus dividend payout ratio)

The growth rate equals the return on equity times the reinvestment rate; simply stated, the growth of dividends is determined by what fraction of earnings is put back into the firm and how profitable those earnings are in their subsequent use. A sustainable dividend growth rate is thus critically linked in finance theory to ROE.

In short, if the focus is on dividend growth, according to this particular model of equity valuation, it could be beneficial to reinvest a larger proportion of earnings AND have those earnings be strongly profitable, in the form of a high ROE.

Index Characteristics as of May 31, 2013 Index Screening

Index Characteristics as of May 31, 2013 Index Screening

For definitions of terms and indexes, visit our Glossary.

Earnings Retention: The earnings retention rate of firms within the WisdomTree Global ex-U.S. Growth Index is significantly higher than that of the other indexes listed. All of these indexes focus solely on dividend payers, but we believe this result is a direct focus of weighting schemes focused on yield. One way to generate yield is to pay out a higher proportion of current earnings, but the fact is, this higher current payout (and lower earnings retention) may hurt future growth potential.
• ROE: ROE for firms within the WisdomTree Global ex-U.S. Growth Index is nearly two times that of the other indexes listed. Notably, all of these figures are quite strong, but the direct focus applied in WisdomTree’s methodology certainly emphasizes this attribute.

Conclusion

There is no one way to determine future equity valuation, but the dividend discount model has been around for a significant length of time. We also believe that it makes logical sense that potential dividend growth could be constrained by earnings reinvestment and profitability of those earnings—as it would be these two factors driving the potential generation of cash that could be used to pay higher future dividends. Dividend-focused indexes that employ a variety of yield-focused weighting methodologies may not be the strongest options for those looking for future growth potential.

Read our full research here.

1 William L. Silber & Jessica Wachter, “Equity Valuation Formulas,” New York University, 2013.

Important Risks Related to this Article

Dividends are not guaranteed, and a company’s future ability to pay dividends may be limited. A company paying dividends may cease paying dividends at any time.

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