Managing Capital

People invest in company shares (or purchase equity) mainly for two purposes: For its Dividend Yield in earning a steady or growing return on investment (as dividends) and/or for its Capital Yield in seeing their investments appreciate in value over time in the Share Market.  Generally, the latter assumes more importance over the former. However, some investors going on the theory of the bird in the hand being worth five in the bush, prefer a steady dividend yield to an uncertain future capital yield in the form of (SP) Share Price appreciation. The obvious reasoning behind this preference is that a dividend yield provides a steady cash flow to the investor whereas a capital yield is realizable only on the sale of the shares.

The board of directors of a company may have a variable policy with regard to its dividend payments, or may opt for a consistent policy over a long term. Basically, the board has to decide between paying out a dividend to keep its shareholders happy in the short-term; or retaining the profits for re-investment for further expansion of the company. In making this decision, the company may also take into account:

  • if the quantum of the dividend payment is compatible with their ready cash availability. A possible alternative to keep to your goals while satisfying the shareholders too is to issue company stock in lieu of cash dividends. A disadvantage is that it would result in the sudden drop in the company’s EPS (earnings per share).
  • that paying a constant dividend serves as a positive signal of the company’s current good health to the share market and the outside world. Paying an increased dividend indicates the board’s confidence that it could be maintained into the future too.
  • investors tend to prefer a company retaining and reinvesting dividends instead of paying out at times of high taxation on dividends compared to capital gains;
  • that you need to either cut down on your investment programs or borrow from external sources to fund the dividend payment at times of constrained and/or reserved cash flow. Microsoft Corporation, for instance (founded in 1975) that went public only in 1986 never paid cash dividends until 2003. The principle behind this thinking would apply more aptly to fairly new and fast expanding companies.

To sum up, features of a proper system of company equity management would comprise:

  • Controlled issue of new stock as and when necessary for raising additional funding for ambitious investment projects.
  • Maintaining a steady or continuously growing EPS and DPS (dividend per share) or a constant DPR (dividend payout ratio – as a percentage of earnings).
  • Some companies may maintain both ratios simultaneously; that is, a constant or a steadily increasing DPS ratio as well as a constant DPR. This is very much characteristic of large mature companies in the food industry like Tootsie Roll and Kellogg.
  • Maintaining a steady or increasing SP (Share Price) for its stock. Conversely, cutting back on dividends adversely affect the SP. For example, many companies in the US automobile industry did not reduce their dividends since 1990 despite the recession until their EPS became negative. General Motors went on increasing the dividends until forced to cut back in 2006 after making substantial losses for two consecutive years.
  • Issuing bonus shares to all shareholders or directors or both.
  • Issuing discounted shares to directors or employees or both.
  • Not making dividend payments especially in the initial years with a view to reinvesting same in the business for future growth.

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