How to select a stock- Part V- Retained Earnings and Dividend Income

When you are thinking about investing in a company by owning its common stock, you need to see whether the company is using the profit generated in the best possible manner. There are two ways in which a company can make use of its earnings- return a part of the profits to its shareholders by paying dividend or use the earnings profitably to grow the earnings of the future.

Different companies use different ways of sharing wealth with their shareholders. One company might choose to pay a handsome dividend to their shareholders every year. Another company might decide to use the whole earning for investing in future growth and pay nothing to its shareholders. A third company may choose to pay a relatively small amount as dividend and invest the remaining amount in the business. Here, one could wonder how a beginner could decide which company is a better investment.

You should ask a question- if the company decides to keep the profits with itself, will it be able to generate a better rate of return on retained earnings than the return you would have got by investing it in some other opportunities available with you. If the company can do a better job with the retained earnings than you can in terms of generating a good rate of return, it should retain the earnings. Otherwise it should pay dividend to investors.

You can assess a company’s capability of generating superior returns by looking at the history of earning growth. If the growth in earnings in the past has been superior, you can trust the management with the retained earnings. If there is no history to look through, you should try to understand where the management is trying to invest in future. If you believe that the management is pursuing a worthwhile investment opportunity and can generate a good return reliably, you can trust the management with the retained earnings.

You should consider another factor in your analysis. If the company is giving you dividend, you have got money in your hands and you can earn real return on it by keeping in a safe investment opportunity. However, if you trust a company with retained earnings, there is a possibility that the company may not be able to give you superior returns in future. To compensate for this risk, ideally, the future earning prospects with retained earnings should far outweigh the earnings you can achieve yourself.

You will find that many companies pursuing growth opportunities are not paying dividends to shareholders. Similarly, many companies have matured in their earnings and are generating cash flow on consistent basis have been paying handsome dividends to their shareholders. These companies may not be having growth opportunities that can justify the use of earnings. Which companies you want to invest in depends on your personal judgment of the growth opportunities and your own ability to generate returns on dividend income. If you are in doubt, perhaps you should opt for the safety of dividend income rather than the probability of expected future earnings.

We have two more topics to cover in this series of ‘how to select a stock for investing’. Watch out for the next post in this series next week.