One of the recurring passive-income streams investors can get is dividends from public listed companies.

Shareholders of Public Bank, for example, have been receiving dividends for decades. As stated in Public Bank’s 2020 annual report, if a shareholder bought 1,000 shares when it was listed in 1967 and subscribed to all its issues of rights shares, they would have received a total gross dividend of RM1.5 million.

It is like owning a durian tree. The tree keeps on growing. And, as the tree becomes bigger and bigger, you get more durian year after year.

For a business to pay dividends, it must make enough profit to come up with the cash. If you, as a shareholder, want more dividends every year, the company has to produce higher annual net income.

If you are a CEO, there are two things you could do with the profit made by your company:

1. Pay dividends to shareholders

Shareholders get periodic cash payments as passive income a few times a year, whether quarterly, half yearly, yearly, or sometimes special one-time payouts.

2. Retain the earnings in the company

You could retain the earnings to pay off debts, reinvest, buy back shares if you think the company stock is undervalued, or keep as a cash reserve.

There are several reasons companies pay out dividends, such as the following:

• to please shareholders by providing them with passive income;
• to abide by the dividend distribution policy, which establishes the principles to ascertain amounts that can be distributed to equity shareholders; and
• because there’s no other reason for the company to keep the money.

So, when would it make sense NOT to pay out dividends?

1. There is a better use of the money

For example, the stock price is depressed and undervalued. You could use the money to buy back shares so investors who want to exit get a better price, while outstanding shares are reduced.

Then there’s the option of reinvesting the earnings to produce even more income. For companies that are still growing, the money would be useful for expansion – assuming the management knows what it is doing, and does not make mistakes such as an acquisition that doesn’t provide synergy, a new venture that turns sour, or dodgy transactions.

2. There’s a tax advantage

Dividends are considered taxable income in the United States, United Kingdom, Australia, and most western countries. Unlike Malaysia, Singapore, and Hong Kong, the dividends received by an individual are tax-free.

Shareholders can sell shares if they need money, which is considered a capital gain. In the US, capital gain is taxed at a lower rate for stocks held over a year. Essentially, shareholders have more flexibility, and are not forced to pay taxes for dividend income.

In conclusion, yes, it makes sense for some companies not to pay dividends – as long as its leaders are wise enough to generate even more returns using the retained earnings.

This article first appeared in kclau.com. KC Lau’s first book ‘Top Money Tips for Malaysians’ has sold thousands of copies. He launched the Money Automation System, the first online personal finance course specifically designed for Malaysians, and co-founded many other online financial courses including the Bursa Method, Property Method, Founder Method and REIT Method.