Dividends are essentially pay outs that companies make to shareholders as a means of rewarding them for their continued investment. They are an ongoing incentive for investors to remain with the firm, fostering a sense of loyalty to the business. These dividends are of course made possible through the firm obtaining a net profit, from which they can choose to re-distribute funds among shareholders.
Pay Out or Invest In? When companies find themselves with an excess of capital following the payment of operating costs, they have a choice to make. They can either keep the flow of income within the business, or elect for a certain portion of it to form a dividend. How this decision is made really depends on the nature of the business and where it is at in its perceived development.
An Eye towards the Future If a company is relatively new, or looking to grow and expand a great deal in the near future, they will often forgo paying high levels of dividends. The idea behind this is that it will free up profits to be re-invested into growing the business. Entering into a foreign market, creating a new product offering, or generally increasing ones market presence, costs money; therefore a company with a long term focus may elect to cut back on dividends as a way of fast-tracking future goals.
Look to Stay Balanced The percentage of profits paid out as dividends will differ between firms; this calculation forms the 'payout ratio' of that company. For instance, if a company used all of its available profit margin for making dividend payments they would have a payout ratio of 100%. In most cases it is advisable to find some sort of balance between internal investment and looking after your shareholders. In effect the two concepts are related, as the more you invest in growing your business, the greater the opportunity for steady, long-term dividends.
Know What it is You Want While there are times when investors will be willing to take a risk on short term gains, owning shares is ostensibly a long term project. In order for your portfolio to grow (without assuming too much risk), you must allow your chosen companies to experience growth of their own. If this means giving up the prospect of higher immediate dividends, then so be it. As the story goes; give a man a fish and you feed him for that day, teach a man to fish and he'll never go hungry again. Learn to fish for the most rewarding long term prospects and you give yourself the best chance at prosperity.
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