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The Dividend Dilemma: Retain Profits or Pay Them Out?

23 August 2016

Dividends are often a point of contention among shareholders. One school of thought preaches that a good dividend payout is better than capital returns. The rival school says the opposite. Both schools have pros and cons. But it's all very subjective, isn't it?

It helps to look at your stock as you would your own business (after all, it is a business you own). For example, say you have a bakery-cum-fast food shop - the only one of its kind in town, giving it a competitive advantage. You also have a loyal set of customers and ample room for expansion. In the first year of operation, you earned good profits - Rs 50 on your invested capital of Rs 100 for an ROE of 50%.

Now, with the kind of response you've had in the market, you know that there is room for expansion. And that turns out to be the best investment opportunity available.

What you would do? Take out the Rs 50 profits out of your business or reinvest it into the business?

In his 1981 letter to shareholders, Warren Buffett talked about dividends:

Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that small shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital towards more attractive areas.

Here, Buffett is saying the prime objective should be to enhance wealth - i.e. invest or remain invested in the best available opportunity. Needless to say, if the company earns better ROEs than other asset classes, and is expected to continue to do so for some time, then retaining profits makes more sense.

Now, imagine your bakery remains a cash-generating machine. Except now more bakeries have entered the market. Demand is limited and largely fulfilled. This means investing your profits back into the bakery isn't as good of an opportunity as it once was. So you start to consider other options for your surplus cash - investments that can give you better returns for some time to come.

Even though your bakery business generated the same profits in both scenarios above, the decision to use the surplus cash was different. In both cases, you did the best you could be considering the prime objective was to invest the surplus money in the best option available at that time.

The same applies to dividends in companies.

So when we look at dividend policies, it's a good idea to step into the shoes of the management and ask ourselves how would we behave if we were managing the company.

We should do whatever earns the maximum returns for shareholders. Since the prime objective is to enhance wealth, it doesn't matter if the best returns don't come from reinvesting in the same company. If another opportunity is best, perhaps dividends are in order.

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