When a company makes money, it has a choice about what to do with the resulting cash. It can keep the immediately use the money to reinvest in growing its business, or it can save the money intending to use it for internal investing opportunities at a later date. Conversely, it can choose to return the cash to its shareholders, typically through a dividend distribution. Which choice is best depends on a company's particular situation. Let's take a closer look at this key decision and what the implications are for a company and its shareholders.
Keeping the cash to build up shareholders' equity If a company decides to hold onto its cash for later use, then it will have the impact of raising its shareholders' equity on the balance sheet. The cash will increase the assets on its books, and so a corresponding increase in shareholders' equity will be necessary to keep its financials in balance.
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In addition, its book value will rise if it keeps its cash. In many cases, that will in turn help its share price go up.
Making shareholder distributionsBy contrast, if a company pays dividends to shareholders, then its balance sheet will end up in essentially the same condition after the two events. Earning a profit will generate the cash that then goes toward the dividend, leaving the net amount of cash on the balance sheet unchanged. Because the value of the company's assets stays the same, there's no need for shareholders' equity to change.
For shareholders, the net result is typically no change in the value of their stock. However, the cash payment they receive rewards them for their investment.
Reinvesting in the businessOften, the best choice for the company and for shareholders is to reinvest available cash in the business. If the business has internal investment opportunities with returns that are higher than individual shareholders can achieve on their own, then shareholders should prefer to leave their cash with the company to take advantage of those opportunities.
That's the reason why many mature companies pay higher dividends than young companies that are just getting started. Larger companies reach a size at which incremental investments yield relatively small returns, but smaller companies typically have more high-return investment opportunities than they can take advantage of with limited cash. By making smart capital allocation decisions, companies signal their views of their future prospects.
It's important for companies to earn profits. But what they do with those profits can make an even bigger difference. Watch closely to see how the companies you invest in handle their cash, and you can learn a lot about their current situation and their expectations and hopes for the years to come.
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