One of the recurring passive income streams investors can get is dividend income from public listed companies. For example, shareholders of Public Bank have been receiving dividends for decades. As stated in Public Bank’s 2020 Annual Report, if a shareholder of Public Bank bought 1000 shares when it was listed in 1967 and subscribed for all its issues of rights shares, he would have received a total gross dividend of RM1.5 million.
It is like owning a durian tree. The tree keeps on growing. And, as the tree becomes bigger and bigger, you get more durian fruits year after year.
Where do dividends come from?
First and foremost, we must understand the origins of a stock’s dividends. For a business to pay dividends, it must make enough profits to come up with the cash. As a shareholder, if you want higher dividends every year, the company must also produce higher net income every year. Only then the “party” can continue.
What if a company makes profits year-after-year, but doesn’t pay out a single cent in dividend? Is that okay?
The usage of Stock Earnings
Now I would like you to imagine yourself being the company’s CEO. This year your company made $10 million profits. What would you do with the profits?
There are many things you can do with the money. Generally, you can do two things.
#1. Pay dividends to the owners a.k.a shareholders
The common phrase we usually encounter is “rewarding shareholders”. Shareholders get periodic cash payments as passive income a few times a year, whether quarterly, half-yearly, yearly or sometimes special one-time dividends.
#2. Retain the earnings in the company:
So with that money, you have many options:
- Pay off debt – you can pay off loans to save the financing cost
- Reinvest – e.g., hire more people, open more branches, acquire other companies, increase R&D spending, etc.
- Buyback share – when you think the company stock is undervalued
- Keep as cash reserve
Being the head of the company, how you allocate the fund has a significant impact on the company’s future earnings. If you are the CEO and decide to pay out a portion of the profit to shareholders as a dividend, what could be the reasons?
What are the best reasons to pay dividends?
There are many reasons to pay out dividends.
#1. To please shareholders
Who doesn’t like passive income, right? That’s why we commonly hear the term “rewarding shareholders”. And the best way is to give them money! Paying dividends is one the best ways to make shareholders happy.
#2. Abide by the Dividend Distribution Policy
For example, REITs have to pay out 90%-100% of their income to unitholders.
#3. Keep your promise
Some founders spell out their dividend policy. So to be consistent, they keep their words. It might be the company’s policy to payout, say 50% of their earnings, as dividends.
However, in my opinion, the best signal for me to pay out a dividend is when there is no better use of the earnings.
#4. Have no better use of the money
I think this is the best reason to pay dividends. It is when the company simply has too much cash and doesn’t know how to deploy it for better usage.
For example, let’s examine the choices to deploy the retained earnings.
As a CEO, you can use the retained earnings to:
- Pay off debt – what if the interest cost is extremely low? What if there is no outstanding loan at all? Then you won’t use it for this purpose.
- Reinvest – what if your market is saturated? There is no more room for business expansion? Or is the risk too high? When a company has nowhere to invest, it shows that the business is at sunset.
- Shall you use the money to buy back shares from the open market? It only makes sense when the stock price is lower than the perceived value. If not, buying back shares at an extremely high price just destroys the company’s value.
- Keep as cash reserves. But when a company has too much cash reserves, the money becomes a drag to the company’s performance. Why not just return the cash to its shareholders? Therefore, investors could have the option to better deploy the capital to other more productive places.
So, in my opinion, if the management doesn’t have better things to do with the retained earnings, I would prefer the management to pay the money to shareholders in the form of dividends.
Why does it make perfect sense not to pay any dividend?
So by understanding the flow of the business’ profit, I guess you now comprehend the logic behind paying dividends. Definitely, there are many circumstances where it makes perfect sense for a company not to pay dividends at all.
#1. There is a better use of the money
For example, the stock price is depressed and undervalued. You can use the money to buy back shares from the market so investors who want to exit get a better price while reducing the outstanding shares. You will have the same pizza with fewer slices, so each shareholder gets a bigger piece.
The best option, invest the retained earnings to produce even more income. For companies that are growing rapidly, they need the money to expand their business. This is only good when the company is investing in creating more value. On the contrary, it is a red flag if the management makes many mistakes. For instance, an acquisition that doesn’t provide synergy, a new venture that turns sour, or some hanky-panky related-party transactions.
#2. Tax advantage
Dividends are considered taxable income in the US, UK, Australia, and most western countries. Unlike Malaysia, Singapore, and Hong Kong, the dividends we receive as an individual are tax-free.
For example, Apple already pays taxes to the US government at the company level. And when Apple pays shareholders like us using the after-taxed income, we get taxed again. For a non-resident, the tax rate is at 30% flat.
A classic example is Berkshire Hathaway, managed by Warren Buffett. Berkshire is a cash-rich company, holding approximately US$200 billion in cash at one point. But the stock has not paid a dividend for the past few decades because of the reasons I mentioned above.
The reasons are more than reasonable – it makes perfect sense:
- Buffett is a super investor, and he can invest the money to create more returns for shareholders.
- Berkshire buys back shares when its stock price is low.
- Shareholders can sell shares if they need money, which is considered a capital gain. In the US, a capital gain is taxed at a lower rate for stocks held more than a year. Essentially, shareholders have more flexibility, and are not forced to pay taxes for dividend income.
In conclusion, YES! It makes perfect sense for some companies not to pay dividends. As long as the company leaders are great capital allocators and are wise enough to generate even more return using the retained earnings. I would love to have them manage it. Don’t pay me the dividends if you can compound the retained earnings at a higher rate. That’s the main reason I invest in your business. Eventually, the earnings growth will translate into the stock price increase in the long term.
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