Determining Dividend Payout
When Should Companies Pay Dividends?
In the days of falling stock prices, Board of Directors will often
begin to pay dividends to help stabilize the companys stock. Many
investors consider these dividends as a sign of safety and financial
conservatism (which they are in many cases). Dividends in and of
themselves, however, do not necessarily make the company a better
investment. Companies that earn high returns on equity, have little or
no debt, and large room to expand in their current industry would best
serve their shareholders by paying no dividends. Instead, they should
opt to reinvest all of the companys available resources into growing
the value of the underlying business.The shareholders will be rewarded
through appreciation in the stock price.
In other words, a company should only pay dividends if it is unable to
reinvest its cash at a higher rate than the shareholders (owners) of
the business would be able to if the money was in their hands. If
company ABC is earning 25% on equity with no debt, management should
retain all of the earnings because the average investor probably won't
find another company or investment that is yielding that kind of
return.
Taxes and Dividend Policy
The tax consequences are tremendously important. If the company is
earning 8%, and the individual investor can only hope to earn around
8%, the business should still keep the proceeds because of tax law.
Why?
Say, for instance, a small company consistently earning 8% on equity
made a profit of $100,000 last year. If the business reinvests that
money back into itself, the shareholders could reasonably expect the
company to earn $8,000 on the reinvested earnings. If the $100,000 had
been paid out in the form of dividends, it would have been subject to
the investors individual tax rates. For simplicitys sake, lets say all
of the shareholders are in the 30% tax bracket. When the $100,000 was
paid out as dividends, $30,000 would have gone to the IRS, leaving
only $70,000 available to the investor to reinvest at 8%. At the end
of the year, the investors could only expect a return of $5,600
($70,000 reinvested at 8% = $5,600). Over time, the discrepancy can
add up to very significant numbers.
Businesses that operate in mediocre industries (such as steel,
railroads, etc.) with low returns on equity would best serve
shareholders by paying out profits as dividends. Take ALCOA (the
Aluminum Company of America) as an example. According to Yahoo!
Finance, the company has a return on equity of 4.89%. Investors can
almost certainly earn a higher return, even when adjusting for the
adverse tax effects. True to form, the company pays out a lot of its
cash flow to shareholders.
