As shareholders, when a company earns money, we want it handed back to us. However, Eaton Vance reports that since the 1930s, companies have been paying out less and less of their earnings to shareholders. Companies used to pay out 90% of their earnings to shareholders in the 1930s. Now? That number has declined to just over 30%. Managers have inherent incentives to keep money within the company, as their salaries and importance usually grow with higher assets under management. Unfortunately, companies growing when they shouldn't be leads to the eventual loss of capital for shareholders.
The payout ratio is not as bad as it sounds, however. Share buybacks, though not ideal as we've discussed here, have increasingly become a method by which companies return money to shareholders. Below is a chart from Compustat demonstrating the use of buybacks and dividends as percentages of cash returned to shareholders over the last several years in the S&P 500:
As we can see, buybacks recently surpassed dividends as a form used to return money to shareholders. If we incorporate share buybacks into the payout ratio discussed earlier, companies have recently been paying out about 50% of their net incomes, as opposed to the 30% which considers dividends only.
A company that returns money to owners allows its shareholders to allocate capital where they see fit. If a company is retaining all its earnings, shareholders must make certain to understand the nature of the new investments, as its their money that's being put at risk.