Dividends and Retained Earnings

Dividends is the profit paid to ordinary shareholders, usually on a regular basis.

The power of that franchise starts to become apparent in the third year. The company makes a profit (earnings), after paying interest and taxes, of US$750,000. The directors now have a choice to present to the equity holders (ordinary shareholders). The company could retain all of its earnings to invest in extending the network (retained earnings) or it could payout some (or all) of it to shareholders in the form of dividends. Note that, whichever course of action is taken, the money belongs to shareholders - earnings retained in a business are there because shareholders consent to their money being left there.

Suppose that the directors (with the agreement of the shareholders) decide on a 50 per cent payout ratio, that is, half of the earnings after tax are paid out in dividends. The shareholders will receive a dividend of 25p per share (US$375,000 divided by 1,500,000 shares).

The retained earnings of US$375,000 increases shareholders' funds from US$1,400,000 to US$1,775,000. So, shareholders have not only received a 25p dividend for each share they hold, but the retained earnings have increased the asset value of each share in the company from 93.33 pence to 118.33 pence (US$1,775,000 divided by 1,500,000 shares).

It is crucial to note that 118.33p does not represent the value of one share should you wish to sell. There will be plenty of people willing to pay a lot more than this to buy the right to receive all the future dividends from a company with such a strong market position. There is every reason to believe that the earnings and dividends per share will rise by large percentages over the next decade or two. Perhaps someone will pay US$10 per share, or maybe even US$100, for a fast-growing company of this kind. Not bad, considering that you paid only US$1.