Dividend – What is a dividend?
With a dividend payment companies take their owners in their profits. The amount of the dividend is determined by the body responsible for it, for example, the general meeting of stock corporations and the cooperative meeting of cooperatives. As a rule, companies spend only part of their profits, while others use them for retained earnings and for investments. There is no guarantee that these payments will be made, depending on the economic situation and the decisions of those responsible. This distinguishes dividends from interest payments that are based on a contractual agreement.
The dividend as one of two earning opportunities
Shareholders can multiply their money by two options:
They sell the shares at a higher price than the purchase price; for example, they strike a return on a share through price gains.
They report regular dividend payments from companies, and many companies distribute these investments once a year.
Anyone who wants to evaluate an equity investment economically must therefore take a close look at both types of income. High dividend payments are worthless if at the same time the value of the company participation decreases. On the other hand, an investment without distributions can make sense, if at the same time the goodwill increases significantly. For equities, the index of the dividend yield has established itself as an important yardstick. It quantifies the dividend payment based on the current share price. For example, if it is at 100 euros and the group pays 5 euros per share, the dividend yield is 5%. However, this ratio does not say anything about the reliability of the distributions and the future performance of the share price.
How is the dividend policy going?
Companies implement a different dividend strategy. For example, public companies often pay little or no dividends in the IT sector because they invest profits in expansion. They are primarily about increasing the company value. Other corporations, on the other hand, attract shareholders with high dividends.
What are the reasons for profit retention?
Basically, companies have two options for the use of profits. The profits may be distributed as a dividend to the shareholders or retained to be used for different purposes.
If profits are not distributed to the shareholders, they increase the company’s equity. This can reduce the debt-equity ratio, improve the capital structure and thus the creditworthiness of the company. As a result, it is easier for the company to take out new loans. The advantage of profit retention for internal financing is the repayment and interest free of funds and that there are no costs for raising capital. The funds allocated to equity capital are also available to the company over the long term. A disadvantage of the retention of profits is from the point of view of the shareholders, that they must give up profits.
Retained earningsWhat are the tax implications of profit retention?
A company is usually subject to the assertion of profit. The amount added to retained earnings generally corresponds to net income after tax. In most countries, no tax is payable on the cumulative profits of a company. This creates potential for tax avoidance, as the corporate tax rate is usually lower than the higher marginal tax rates for taxable owners. The owners could “park” income within a private company instead of paying it as a dividend, which then has to be taxed at the individual rates.
To eliminate this tax concession, some countries impose a tax on the retained profits of private companies, usually at the highest individual marginal tax rate. The issue of bonus shares, even if funded by retained earnings, is not treated as a dividend distribution in most countries and does not need to be taxed by the shareholders. As profit retention increases the company’s equity, the value of the business for each shareholder increases over time. This increase in value usually increases the share price, which may result in a tax at the individual tax rate on realized profits when the shares are sold by the holders.
Retained earnings for investment funds
For investment funds, a distinction is made between accumulating and distributing funds. A distributing fund regularly pays the profits made to the investors. In the case of a reinvestment fund, the profits are retained, which increases the fund assets and thus the unit value for each investor over time.