When a business pursues the capitalization of profits, what they are doing is a conversion of the retained earnings of the company into capital stock. This process issues either bonus shares or a stock dividend to the existing shareholders. Each shareholder would receive the proportional percentage of the profits in relation to the number of shares they hold in the company.
If you held a 1% stake in the Ford Corporation, for example, then you would receive a 1% share of the capitalization of profits.
A company is not required to pay shareholders the capitalization, however, if they are wanting to invest those funds back into the company. It is also possible to take profits to funnel internal growth while shareholders continue to hold their shares at their current trading price.
There are certain advantages and disadvantages which must be considered when capital is taken from profits. Here are the key points to consider.
List of the Advantages of Capital from Profits
1. It is a sign of continued operations.
Investors are looking for signs of stability when they invest into a company. If the policy of the company to turn profits into capital, then disburse that capital to shareholders, then there is less risk involved to the investor. Even if the share price does not rise or fall substantially, the paid dividends will help to create a line of revenues for the investor. That allows them to build their own portfolio, which can be used to purchase more stock.
2. It stabilizes the market value of the company.
When companies have a history of taking capital from profits, their market value tends to be more stable than companies which don’t have this process as part of their company policy. Although that means investors will not see large swings in the share price each day, it also means that there is confidence in how the company will perform for each quarterly evaluation.
3. It provides investors with confidence.
Companies which take capital from profits are a good choice for long-term investors because there is a higher level of certainty available. Long stretches of paying dividends to shareholders allows investors to slowly build their wealth over time with a minimal risk of experiencing loss. The potential for profits is still there as well, just at a lower level when compared to small-cap stocks that may not offer a dividend at all.
4. It is an option which is suitable for institutional investment.
Many institutions maintain their budgets or expectations of growth by making their own investments into other companies. Berkshire Hathaway is an excellent example of institutional investing on a large scale. For companies to experience institutional investment, there must be a proven record of stable dividends available by taking capital from profits consistently. All investments entail some level of risk. This process is intended to limit that risk.
5. It improves the credit profile of the company.
Taking capital from profits is an indication that a company is trying to grow. It shows that there are profits to be found in the operations of the company. It is also an indication that a company doesn’t want to take on extra debt. That is why the credit profile of a company can improve through this process, which ultimately makes finding financing easier to do if it is required for some reason.
6. It stabilizes the national economy.
Taking capital from profits helps to stabilize the national economy because it is helping to contribute wages and productivity within its industry. Wages allow for individuals to contribute spending power to the economy as well, which fosters growth in other areas as well.
7. It creates long-term success.
Although companies who take capital from profits tend to achieve slower growth than other companies, the returns they offer tend to be comparable to the market as a whole over an extended time period. At the same time, they offer the potential for real-time payments through dividend structures, which allows an investor to keep putting more money into their portfolios instead of waiting for one big sale to make things happen.
8. It creates tax-advantaged opportunities.
Taking capital from profits means that the profits are typically taxed at a lower rate in the United States. This is especially true for investors. Even at the highest tax brackets for income, dividends are only taxed at 15%, while earned income may be taxed at 35%. In the lower tax brackets, there may not be any income tax owed on dividends received from investment opportunities.
List of the Disadvantages of Capital from Profits
1. It limits the efficiency of the business.
Retaining capital from profits makes sense when the profits come in at a higher rate of growth than the prevailing interest rates. Since 2000, the interest rates have been extremely low in the United States. Some interest rates have been below 1% on lending products. On the average year, the average business will earn about 9% on its investments. It makes more sense for the business to access a lending product, use the higher returns for operations, and then grow the business.
2. It limits growth opportunities.
Companies that grow by taking capital from profits tend to grow more slowly than the companies who are willing to take on some debt. Although not taking debt on contributes to a healthier bottom line for the company, it also means that there may not be money available for specific growth opportunities when they appear.
3. It may limit the attractiveness of the investment.
There are two specific issues to look at here. If a company retains its profits and does not distribute them, then even profitable companies become less attractive to potential investors because there is more risk involved. For a company that is generous with its dividends, there is still less attractiveness for some investors because of the limited growth opportunities in share value compared to some small-cap stocks.
4. It can limit diversification.
Many of the companies which are in a position to take capital from their profits are found in either the tech sector, the utilities sector, or the older industrial sector. This limits the diversification opportunities for investors, as the companies all tend to operate under the same market conditions. That means investors who focus on companies that take capital from profits solely run a higher risk of losing their investments.
These capital from profits advantages and disadvantages suggest that converting capital from profits is a healthy way to do business. It limits debt, provides growth, and encourages investors to get involved. It can also hinder certain growth opportunities and make the business look less attractive to some investors.