Investment Shastra

Retained Earnings V/S Dividends?

Retained Earnings V/S Dividends????

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.

Let’s see what they are:

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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4 comments

  • Hi, A company not giving out enough dividends may after all be a positive aspect after all, is an eye opener. And now, I can even figure out whether they are using their retained earnings well. Good!

  • Hi, A company not giving out enough dividends may after all be a positive aspect after all, is an eye opener. And now, I can even figure out whether they are using their retained earnings well. Good!

  • Nice post .

    I can relate above article with decision of choosing weather to invest in Growth or DIvidend option of a stock . It all depends on the investors needs , If he needs a stream of regular income in form of dividends , then going for a company with good dividend paying record makes sense .

    Once the other hand if a person wants to make money by value appreciation over long term (in a sense , he/she loves compouding effect) . he/she can/should invest in companies which redeploy money in the company .

    Manish
    http://www.jagoinvestor.com

  • Nice post .

    I can relate above article with decision of choosing weather to invest in Growth or DIvidend option of a stock . It all depends on the investors needs , If he needs a stream of regular income in form of dividends , then going for a company with good dividend paying record makes sense .

    Once the other hand if a person wants to make money by value appreciation over long term (in a sense , he/she loves compouding effect) . he/she can/should invest in companies which redeploy money in the company .

    Manish
    http://www.jagoinvestor.com

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