Do Common Dividends Have an Influence on the Return of Equity?

by Joe Escalada

    Many investors enjoy cash dividends as a source of income. Often, they view higher dividend payments as being better than lower dividend payments. This is not always true because these payments deprive companies of cash that could have been reinvested. Dividend payments likely wouldn't be preferable for investors when the company could have used those funds to launch high-return projects. If the company can reinvest money at a higher rate than its return on equity, then these investments will boost ROE for the entire company and increase shareholder value.

    Return on Equity

    Return on equity is the net income of a company divided by the average value of owners' equity over an accounting period. It also can be calculated by dividing the value of equity at the end of a period by the value of the equity at the start of a period. These calculations reflect how ROE is a rate of growth in the accounting value of the owners' stake in a company.

    Leaner Equity

    Cash dividends reduce the owners' stake in a company. In doing so, they reduce the denominator of the ROE calculation. This can boost ROE if the numerator, the income, stays the same. In this scenario, a dividend payment helps ROE because the money was just lying around and was not generating value for shareholders.

    Starved Companies

    Some companies need cash to grow or to remain liquid. Cash dividends can force companies to delay or abandon high-growth projects. Aggressive dividend policies also can force companies to issue new shares or borrow at undesirable rates. Management should reduce dividend payments in these scenarios to protect shareholder interests.

    Stock Dividends

    Unlike cash dividends, stock dividends do not change the total value of a company’s equity. Distributions of less than 20 percent of outstanding shares are categorized as small stock dividends and reduce retained earnings while increasing paid-in capital and common stock by the same amount. Distributions of more than 25 percent of outstanding shares are called large stock dividends and shift value from retained earnings to common stock. Stock dividends do no change total equity and do not affect ROE.

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    About the Author

    Joe Escalada is a financial analyst. He earned a Master of Business Administration from the University of California at Davis and has passed all three Chartered Financial Analyst examinations. He has a bachelor's degree from the California Institute of Technology.

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