What is Dividend and Dividend Payout Ratio

Dividend Definition

Dividend is the share of Company’s profit which is distributed among the shareholders of the Company. It is the return on the investment in the shares of the Company.

Dividend - The Legal position, procedure and accounting

There is procedure laid down in the Companies Act and the rules framed there under regulate the dividend payment which are as under:

  1. Dividend can be paid only out of profits of the company from its ordinary operations in the relevant year or in the previous years after making provision for depreciation and amortisation in all such years
  2. Capital profits resulting out of sale of assets can be utilised for payment of dividend if and only if the same is realised.
  3. Dividend can be declared only after the minimum percent of the profits as prescribed in the Companies Act is transferred to reserves.

After complying the above referred conditions, the Board of Directors can recommend the dividend to shareholders for approving at the annual general meeting. In case the Board of Directors decide to pay dividend before the financial year ends, such dividend is termed as Interim Dividend. Such dividend can be paid without the prior approval of shareholders. However, such interim dividend needs to be approved at the subsequent board meeting. Upon Board approval in case of Interim dividend and after shareholder’s approval in case of final or normal dividend, in order to ascertain the eligible shareholders, Company declare the book closure i.e the period in which share transfers are not recorded in consultation with the Stock Exchange. Management philosophy (conservative/liberal), adequacy of profits, nature of business, expansion plan, corporate image, legal requirements, peer pressure(competitors declaring dividend) decide the dividend distribution.

Dividend Payouts and the Dividend Payout Ratio in the Equity markets

We've learnt about Dividend Payouts and the dividend payout ratio in the article about EPS - Earnings per share. Some Important thoughts about Dividends and how investors should analyse Dividends

  • Firms with higher cash flows are better investments than firms with only accounting profits. Cash Flows are a better way to judge the quality of a company. Usually, firms with higher cash flows also have a higher dividend payout ratio

Dividend payout ratio is the ultimate test for judging the quality of earnings - Bharat Shah

"Growth of earnings is a very powerful factor in value creation. Ultimately, compounding power of a business is slave to earnings power but payout ratio has a very important dimension to add to the growth of earnings. In other words, like an exceptional ROCE adds a greater character to the earnings growth, similarly a greater payout ratio also adds another character or dimension to the earnings growth. So, the two qualitative attributes which define an earnings growth are capital efficiency as well as the dividend payout. Capital efficiency is the description of the character of the business and capital payout would represent an important test for the management. In other words, the fact that value created from a business, over a period of time, would be strongly co-related to the underlying earnings growth, can be altered favorably or unfavorably depending on the superiority of the payout ratio.

Therefore, vis-à-vis earnings growth, a payout is a greater test of motherhood (a matter of certitude) while earnings growth is more like a fatherhood test (a matter of belief). This is because dividends would come by only if profits convert into cash flows and they would be paid out only if the management has the wisdom not to keep excess cash on its balance sheet and distribute all the cash that is not required in the business. Typically, a great business would be represented, more often than not, by a great payout ratio. Equally, a good payout, over time, is a clear indication of a good business. Given that a good payout usually goes along with a good business, a persistent decline of dividend payout would be a marker for the diminishing compounding power of the business.

As the superiority of the business proposition diminishes, so does the dividend payout ratio and so does the power of compounding. Low dividend payout ratio with a high ROCE is a rather unusual condition because high ROCE implies a capability of a business to sustain high growth without needing the external capital. So, such a business is expected to have a good payout without any compromise on growth rates. Unless there is a capital misallocation or the growth is exceptionally high, the payout ratio has to be high. Payout ratio is a very powerful affirmation of quality of earnings. The profit growth of a company shows the engine power of the company as well as the untapped market opportunity for the sector. While it is a very important parameter of the financial statements, it holds no meaning unless supported by capital efficiency and prudent capital allocation.

Growth in cash flow, on the other hand, is a better indicator of the health of the company and its earning potential. In a limited period of time, profit growth can also be achieved by accounting jugglery and window dressing, which is not possible for cash flows. Profit is a matter of belief, akin to fatherhood, while cash flow is a matter of fact, akin to motherhood. So, it is fair to believe that the companies which have a better and a consistent dividend payout policy have a character of the business to so afford, as well as, it provides higher clarity and certainty of the financial statements than otherwise." Investors can check the dividends on the BSE website - http://www.bseindia.com/corporates/corporate_act.aspx?expandable=0

Reference Article

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