As we have seen, stockholders have effectively bought an ownership interest in the company they have invested in; and as part owners of a business they benefit from both the company’s actual profitability and from others expectations of future profitability.
However, being in a position to benefit from a company's profitability is not the same as ‘getting the company’s future profits.’ All net profits are technically owned by the shareholders but are controlled by company management. There are two things the board of directors can do with that net profit:
- Pay net profit out to shareholders as cash income – a dividend payout
- Retain net profit to reinvest in the business
We will start by looking at dividends.
Paying out some net profit as dividend income is the most obvious part of a shareholder’s returns. A dividend is like an interest payment on a deposit account …except for the fact that it is not a guaranteed income-stream. A company can increase or cut the dividend as it sees fit.
Take, for example, a company with net profits after tax and debt service of $50 million. Let's assume the company distributes $20 million to shareholders in dividends and retains $30 million for reinvestment. Who gets what?
When a dividend is paid shareholders receive an amount proportionate to their shareholding in the company - proportionate, that is, to their ownership interest. So, if our company has 20 million issued shares, each share held would be due $1 in dividend payments.
In these circumstances, a shareholder owning 2% of the company (400,000 shares) would receive $400,000, a shareholder holding 100 shares in the company would receive $100 and so on.
Traditionally, dividend income was seen as the main benefit of shareholding, and it tends to be older, well-established companies in mature industries which payout the highest proportion of their profit to shareholders.
This is partly because these companies have a lot of shareholders who were originally attracted to the share by the regular income-stream (Pension Funds, Life Assurance companies and retired individuals) and any fall in income would not be appreciated. But it is also because these companies are well-established and tend to have stable annual cash flows – so they can keep paying fairly steady, consistent dividends which should grow roughly in line with background economic growth.
Of course, it is only right that a dominant company in a mature industry should pay out net profits to shareholders. And, being a stable, secure, asset-rich highly creditworthy company, any cash it does need, it can easily borrow – at highly competitive rates.
Retaining profits is something for expanding companies to do. But how does that benefit shareholders?
