Contrast a stable dividend policy with a constant payout ratio policy and work out the dividend each would produce
The idea
A stable dividend policy smooths payments so that they rise gradually with sustainable earnings. It is often modelled with a target payout adjustment, in which the expected dividend is D1 = last dividend + (expected EPS × target payout − last dividend) × adjustment factor, where the factor is one divided by the number of years over which the gap is closed. A constant payout ratio policy pays the target percentage of each year's earnings, so dividends move one-for-one with earnings and can be volatile. With a 1.10 dividend, EPS of 4.00, a 40% target and four years, the dividend is 1.10 + 0.50 × 0.25 = 1.225. The trap is applying the factor to the whole target dividend instead of to the gap.
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