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Dividend Decision: Retained Earnings vs. Dividend Decision

DIVIDEND DECISION

The Dividend Decision is one of the crucial decisions made by the finance manager relating to the payouts to the shareholders. The payout is the proportion of Earning per Share given to the shareholders in the form of dividends.

The companies can pay either dividend to the shareholders or retain the earnings within the firm. The amount to be disbursed depends on the preference of the shareholders and the investment opportunities prevailing within the firm.

The optimal dividend decision is when the wealth of shareholders increases with the increase in the value of shares of the company. Therefore, the finance department must consider all the decisions viz. Investment, Financing and Dividend while computing the payouts.

If attractive investment opportunities exist within the firm, then the shareholders must be convinced to forego their share of dividend and reinvest in the firm for better future returns. At the same time, the management must ensure that the value of the stock does not get adversely affected due to less or no dividends paid out to the shareholders.

The objective of the financial management is the Maximization of Shareholder’s Wealth. Therefore, the finance manager must ensure a win-win situation for both the shareholders and the company.

Objects of Dividend Decisions

(i) Cash Requirement: The financial manager must take into account the capital fund requirements while framing a dividend policy. Generous distribution of dividends in capital-intensive periods may put the company in financial distress.

(ii) Evaluation of Price Sensitivity: Companies chosen by investors for its regularity of dividend must have a more stringent dividend policy than others. It becomes essential for such companies to take effective dividend decisions for maintaining stock prices.

(iii)Stage of Growth: Dividend decision must be in line with the stage of the company- infancy, growth, maturity & decline. Each stage undergoes different conditions and therefore calls for different dividend decisions.

(iv) Good Dividend Policy: There does not exist a single dividend decision process that works for every organization. A decision suitable for one company may prove fatal for another company. For example, businesses with a consistent order book such as telecom and banking are expected to pay regular dividends. It may impact the stock prices if they do not pay dividends regularly. To the contrary, sectors of pharmaceutical and technology are highly research oriented. Huge cash expenses are required to further their operations. Therefore they cannot afford to pay a regular dividend. Investors of such stocks earn income mainly through capital appreciation. In essence, there are a lot of factors affecting dividend policy or decision.

Types of Dividend Decision

There are various types of dividends and dividend decisions.

(i) Stable Dividends

  • Same amounts of dividends are paid out every year irrespective of the profitability.
  • Shareholders remain immune to fluctuations and volatility faced by the company.
  • Only long-standing and established companies with steady cash flows can afford to follow this policy
  • Investors that buy into these companies have a low risk appetite. They also do not get to participate in the profits of the company

(ii) Constant Dividends

Dividends are paid at a fixed percentage of the profits.

  • The brunt of recession is as much borne them as much they reap benefits of the boom.
  • This policy is suitable for companies in their infancy stage as well as those prone to volatility.
  • Investors of these companies are risk-taking. They prefer to swing with the company in its earnings

(iii) Alternate Dividend Decisions

A company may not always issue the dividend in cash. A stock dividend is a significant option with the management for recourse to non-cash options. It is a handy tool to which management may resort to when it wants to balance both, shortage of cash and shareholder expectations. Such decisions are only made in exceptional circumstances.

Retained Earnings vs. Dividend Decision

Which one do you choose? A company that declares dividend or a company that retains the profit???

This is always a tricky question & there are always different views on this topic.

The general perception people have is that by not paying dividends or not increasing the dividend policy the company is doing no good for the investors. This may or may not be true.

The good side about retaining the money is that the company may be investing the money in a fruitful project which may give you better returns a little later. The company may have intentions of launching a new product/service or building a new plant or probably is going in for expansion.

And the bad side?

There a few cases when a company does not benefit from the retained earnings. When does that happen?

  • When the management piles up cash far beyond its present or short term needs.
  • The next is when the management has been getting a sub standard return on its capital and uses the retained earnings to enlarge the effect.
  • Also, when there has been a fraud in the accounting method followed, the retained earnings prove to be of no benefit.
  • In some cases the retained earnings may be needed but they are of no use to the investor. In cases where the retained earnings is a necessity but in no way increases the operational efficiency. For example: A large retail mall investing in a central air conditioning system. It requires a large investment but it does result largely in an increase in sales.

Hence, the only way you can take a call on whether dividends are better or retained earnings is by checking the difference in the benefit of both. This analysis & decision is very company specific.

Now, how will you figure out the difference in the benefit of both?

A company retaining its earnings can be checked by looking at its ROE & ROIC. If the return gained on the retained earnings is higher than the dividend it would have declared you are obviously at a benefit. When the company declares dividend how do you check your benefit? Find out if the company has any growth & expansion plans. If not, then why? If yes then probably the company did not need more of the retained earnings to implement the growth plans. Check what kind of plans are those and why the company did not need more of the retained earnings to implement the growth plans. Whether it is due to the nature of the industry or is it because of the size of the company.

Hence, don’t jump to conclusions regarding a company’s dividend policies. Study the company properly, its objectives & its plans.

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