Sunday, March 7, 2010

A common form of corporate ownership - Sharing the Loot

When a company makes a profit, the after-tax profits, owned by the shareholders may be used in a variety of ways for the benefit of the shareholders. First of all, the company may re-invest the profits to upgrade its operations or use it for the acquisition of a new production facility or another company that adds to its value(for a variety of reasons such as additional earnings, increased market share or technological innovation).

To invest after tax earnings or net income into corporate expansion requires that shareholders probably will benefit from this re-investment. If the company does feel that not all profits need to be reinvested, it may pay the remainder of the profits to shareholders as dividends. The company’s board proportionally divides the earnings between reinvestment and dividends and the dividend/earnings ratio is often called ‘payout ratio’. The ratio of dividend paid per share versus the share price is called dividend yield.

Paying out dividends triggers income taxes for investors and to mitigate this, a company may decide to buy back outstanding shares of the company instead. As a result, in following years the earnings will have to be divided amongst fewer shares and the share value will rise accordingly. This will not trigger income taxes or it will trigger capital gains taxes if the investor decides to sell some or all of the appreciated shares, where capital gains taxes are less than taxes paid on dividends.

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