Let’s say a company listed on a Stock Exchange has made a decent profit and wishes to pay a dividend to its shareholders. For the sake of argument the profit is £10 per share. What should it do?

What is usually done is to pay out a third of the profit, £3.33, as dividend, and re-invest the rest. There are two good reasons to do this:

(1) Shareholders expect not just dividends, but dividends which grow over time. Re-investing some or most of the profit in making future profits is the way to ensure this.

(2) In the following year, the profit made might actually fall. Just the same, shareholders expect a steady stream of dividends. The company has a reserve of retained profit of £6.67 brought forward from last year, and is in a position to pay an increased dividend, say £3.43, even though profits have fallen. It can hope to make more profit in the third year.

Sometimes the £6.67 worth of retained profit cannot be invested in anything useful within the business. In this case the company can do one of two things:

(a) Reinvest retained profit by taking over another company in a different industry. This was the fashion at one time, with the rationale that management skills are transferrable from one industry to another. Great corporate empires were built up as companies got taken over.

(b) Pass back the profit as a special dividend to shareholders, and let them decide for themselves what else they may wish to invest in. Experience suggests that management skills are not so easily transferrable, and this is the modern trend.

In practice, the value of a share is the value of its expected future stream of dividends, discounted by a standard rate of return such as the average rate achievable on government bonds. The foregoing remarks on paying a dividend should make it obvious that the value of a share can be quite volatile, and this is indeed a matter of experience. In the long term the value of a bundle of shares held in different companies should increase by a decent margin over the rate of inflation, but in the short term even a well-diversified shareholding can fall in value. 

David Porthouse & Co is a forward-looking firm of accountants based in Carlisle with a keen interest in new technology with the aim of speeding up accounts production and making accountancy more affordable for our clients. David Porthouse is also a specialist in company accounts and corporation tax.