Updated: Tue, 04 Oct 2011 14:00:00 GMT

When should companies pay dividends?

Today's pre open talks about when should companies start paying dividends.

In an exceptional move, the shareholders of realty major Unitech Ltd at a recently concluded annual general meeting (AGM) rejected a management proposal for payment of dividend amounting to about Rs 300 m for the year ending March 2011. The shareholders felt that the company should rather utilise the funds for business purposes considering the current environment of high interest rates. It is better for the company to pay back some of the debt rather than paying dividends. This example has raised an important question of when companies should pay dividend.

When a company is profitable, it must decide on how best to use its earnings. Some choose to keep the earnings and reinvest them in the company. Others distribute the earnings, or a portion of them, to stockholders as a dividend.

So when should a company pay dividends? Dividends should be paid when a company has free operating cash flow. This is because when a company borrows to pay a dividend, it's clearly not sustainable, as bondholders will soon tire of taking on excessive risks to reward stockholders. However, a dividend that is paid from operating cash flows has a much higher chance of continuing as long as that business can operate profitably. Dividend paid out of operating earnings also carries with it no long term liability thus enabling a company to retain financial flexibility. The company should also ensure there is sufficient cash to pay both the dividend and operate the business. Last but not least, most companies can only grow their ROEso much as they could be reaching the limits of their marketplace. The ROE would then incrementally start declining, making it worthwhile for these stocks to pay out dividends instead of spending the cash on acquisitions to buy competitors or start a division in a completely new sector in order to diversify.

To conclude, it is desirable for companies to pay out some portion of earnings and then reinvest the rest in the business. Long term success comes from good balancing of management and shareholders' interest.

By Equitymaster - India's leading share market research initiative. Our research coverage includes both large and small companies, including the NSE Nifty stocks.

Copyright © Equitymaster Agora Research Private Limited

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