The Dividend Question

To pay or not to pay, that is the question. Well, at least for many corporate managers, it is often one of the most important questions to ask. Cash rich corporations face the critical decision of whether to retain cash or to pay it back to investors in the form of a dividend. The real answer to this question has to do with whether or not a company is growing.

 

Suppose company ABC has significant cash reserves and continues to grow at a double digit rate. Assuming that the company will continue to grow, it probably makes sense to reinvest the cash back into the company to generate new growth opportunities. This may come from acquisitions, new product launches, or new market expansion initiatives. Since the company's resources continue to produce solid returns, it makes perfect sense to reinvest excess funds back into the company. In other words, the cash on hand, when invested back into the company, will produce higher investment returns than simply holding the cash in a bank account or handing the cash back to investors.

 

Now, suppose Company ABC sees a slowdown in growth. While the company remains profitable and cash flow positive, each year is starting to resemble the last. In other words, deploying more cash into new initiatives will unlikely yield any noteworthy change to the core business. In this case, the best strategy is to return the money to the shareholders who can in turn invest it elsewhere (and hopefully earn a higher rate of return). Such a move by management is often a subtle acknowledgement that growth has slowed and investors should seek higher return opportunities elsewhere.

 

While the dividend decision seems like a simple one on the surface, real life decisions rarely play out in such a siple manner. Often, activist investors pressure a company's board to issue a dividend. The board and management may be reluctant to do so for fear of releasing cash that may be needed in the future. In the end, only hindsight will affirm whether or not a company made the right dividend decision.

 

Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.

 

 

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