Why do companies pay (common) dividends?

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tencntraze

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I’ve read the basic answers on the web, which are about what I expected them to be, but I’m still not getting why companies would like to pay a dividend (though I understand what effect it has on various ratios). A company wants to pay a dividend as it gives the impression of a strong financial backing to investors, I get that part. Do they pay dividends in order to keep the overall share price up (in terms of market confidence, I know the price drops with the dividend)?
A second aspect to this is that the company has already issued shares on the primary market, so generally most of the common shareholders will have bought these ona secondary market; the company does not get any additional money from these transactions. Does this again related to the company wanting to keep shareholders happy?
The arguments for not paying a dividend are of course so that the funds can be used on CapEx, or other investments.
 
If you’ve just bought the chain of stores downtown, and you employed me to run your stores for you, would you be happy if after 5 years of running your business i still haven’t given you a penny in returns?
 
Lifecyle of a business typically determines dividend policy. If you are in the maturation phase, it’s time to start paying owners. If you are in the growth phase, you want to use every last dime you can to gain market share.
Many investors have a strong preference for dividends. Dividend income is much more reliable than the price per share, or cash out value of a publicly traded company. Markets don’t always (most often not) reflect the actual worth of a company. So if a company isn’t paying a dividend and hoarding cash, it might be hard to collect that cash by selling the stock.
 
@bloodline: I might or I might not, depending on my holding interest. In your example, I would expect that I as an owner would have what amounts to a preferred share, which wouldn’t be trading on a secondary market. In this case, yes, I would definitely expect a return on my investment. In the case of common shares, though, if I bought that on the market, none of my money actually goes to the stores, so what incentive does the company have to give me money back?
@pdx914: Many investors do want the divident, agreed. But what is the *company’s* incentive to pay out dividends to common stockholders? Does hoarding cash generally trigger a sign of financial distress to the market? As I mentioned in the previous paragraph, none of the shares trading on a secondary market will have that money go to the company.
 
The main purpose of the business is to provide shareholder with an increase in wealth. In the most basic sense, a company should invest its money in a manner that provides shareholders with best return on their investment. As some have mentioned, younger companies typically invest in capital projects to boost returns. After a point, the return an investor could earn on his own may be higher than what the firm will provide. At this point, a firm should pay dividends to allow the shareholder to maximize the return on his financial capital.
 
A norm, something that makes shareholders happy which gains their confidence and act as a return on their investment. Not all people invest in equity for capital appreciation or hold the securities for trading. They have invested in businesses and expect them to return. With bonds or fixed income securities the return is the coupon and with equities it is dividend. I believe these could be among the other reasons.
 
VaR_99 wrote:The main purpose of the business is to provide shareholder with an increase in wealth. In the most basic sense, a company should invest its money in a manner that provides shareholders with best return on their investment. As some have mentioned, younger companies typically invest in capital projects to boost returns. After a point, the return an investor could earn on his own may be higher than what the firm will provide. At this point, a firm should pay dividends to allow the shareholder to maximize the return on his financial capital.
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I think what wasn’t clicking for me is that many common shareholder did not buy the common stock directly from the underwriter/company when it was issued; it was purchased on a secondary market. As such, a shareholder in this situation has not given any money directly to the company at all, but rather exchanged money with the previous shareholder for the share itself.
This of course doesn’t have any effect from the company’s standpoint. X number of shares are outstanding, so these generated income for the company. They don’t care who holds it, the same number of shares were used for generating cash and this is the company’s way of “thanking” the investors. Still, no one is forcing the company to pay dividends. What’s the negative to not paying dividends? The shares were already purchased, and it’s at the company’s discretion to buy them back, so it’s not like a shareholder can get pissed and demand money back (for the sake of discussion, again we’re talking about common, non-voting shareholders). They could just sell them to someone else on the market.
This whole thought process was triggered by a topic in the general forum regarding why Dell isn’t paying dividends.
@VaR_99: “After a point, the return an investor could earn on his own may be higher than what the firm will provide”. Isn’t this the point where the investor should just sell the stock? Maybe interest rates changed drastically since the stock was originally issued, why should the company take a loss on this?
I think there are many variables to this, so let’s also say that when the company originally issued common stock, there was no basis for believing that a dividend would be issued in the future. If an investor had a reasonable basis for expecting a dividend then yes, I could see them being pissed.
 
If Mr A buys stock at the primary market, he gives his money to the company and expects the company to generate returns with it from the company’s normal operating cycle. Mr A can be said to have an ownership stake in the company. If the company goes kaput, and declares bankruptcy, Mr A should not expect to get his money back, this is the risk he takes. The company compensates for both this risk and his ownership either by paying him dividends from profits, or investing those dividends in buying new asset so as to increase the value of Mr A’s share of the company. In most cases, it will be the latter than the former because many companies approaching the primary markets for funds are more likely to be in their early growth stages.
Now Mr A thinks the directors of his companies have become arseholes, who will rather budget big bonuses for themselves than seek best practices for stakeholders, so he decides to sell his share of the company to Mr C, thus transferring the risk of the company going bankrupt and the likely benefits that comes with holding the stock. He does this on the secondary market.
Mr C is now the new owner of the company. it doesn’t matter that those shares were bought on the secondary market. The secondary market exists for sake of liquidity , so that those wishing to cash out of their investments could do so.
When a company issues common stock, there’s no basis for expecting dividend, but there’s basis for expecting an increase in value for the investment.
Think about it this way, if the price of the company’s stock as at issue is 5 dollars and two years from issue the stock sells for 8 dollars, lets say the company made profit and declared a common dividend of 2 dollars, then the total return to an investor is 2%
Now let’s say the company does not pay out dividend, but saves the cash (2 dollars per share) as retained earnings to be used for future projects, the company’s book value will increase by this amount of cash and in efficient markets, this will be automatically factored in market prices such that the company’s new price will move up from 8 dollars to 10 dollars. In the end, the total return to the investor is still 2%
So either the company pays out dividends or keeps it as assets, shareholders investment is still maximized.
 
I see 3 primary reasons why companies issue dividends (two of which have been addressed)
1. Investors can get a better risk adjusted return on their money than the company - this can also be done through share buybacks which essentially pushes the stock price up (through less shares outstanding) and allows the investor to decide if they want a cash payment be selling the shares. In a liquid market with low costs this works well, it allows investors to individually decide if they want the money or not.
2. To attract investors - many mutual funds (income funds) require dividends to be paid to make the stock eligible for purchasing, other investors rely on the income to support their expenses (i.e. a pensioner) and lastly some investors rely on it as an idicator of financial health for the company which is less easily manipulated. Not paying a dividend reduces your investor base relying in a lower company valuation.
3. To much cash - sometimes too much cash can be a bad thing and while companies like Apple and Microsoft like to hoard huge stockpiles of it, others prefer to distribute it to prevent management from being friviolous with the extra funds.
 
I get the feeling this is more of a corporate governance question than a dividend policy question, and you’re overthinking it. Each share of stock represents a unit of fractional ownership of a corporation. As such, management and the board of directors have a fiduciary duty to the shareholders. Shareholders can and will elect a new board that will represent their interests if the current board and management aren’t. Therefore, in both theory and practice (agency conflict aside), it is in the best interest of “the company” to pay dividends to shareholders when it is in the shareholders best interests. I think that reasons why dividends might be in the shareholders’ best interest have been pretty well covered.
Non-voting stock is entitled to the same dividends as voting stock, so your point there isn’t really valid. If there was no guarantee or incentive for the company to pay dividends, you’re right. They wouldn’t, and those shares would be worth $0. If you’re thinking that the appreciation of value in the stock would be of some value, I think you need to take a look at the dividend discount model. Appreciation in the stock price in theory is based on the increase in the net present value of future dividends. This ignores the possibility of a takeover, but that’s the exception rather than the rule. How do you think the acquiring company is valuing their takeover bid? In any case, the value of a share of stock is based on the net present value of future cash flows.
These are both very simple, but very important points.
 
Thanks everyone. There is no doubt that I’m overthinking this, probably because I’ve been trying to understand the rationale from a non-formulaic approach. I do the same thing with logic word problems, analyzing what a person would do emotionally instead of looking at it from a pure logic standpoint.
 
While everything mentioned above is mostly academically sound, think about it from a common sense perspective. Most high level employees of public companies that do not have preferred stock will have a large amount of common stock. By paying a dividend, a company is also paying the employees. Think of it this way–if Apple pays a dividend, Steve Jobs’ family will receive 5.5 million times that dividend.
 
Basically, if you have profits but can’t reinvest them in the company to generate sufficient growth to deliver returns commensurate to your risk, then you should pay profits out as dividends. Otherwise, you reinvest cash profits back into the company to increase working capital and create the capacity for growth. Alternately, if you’d be paying a dividend, you can buy back your stock, which effectively turns the dividend into capital appreciation by the market impact of increasing the demand for the stock. However, if valuation is very high, it may not make sense to buy back the stock, and a dividend would be better.
Dividends are generally unattractive to taxable investors because they create taxable events, whereas share buybacks allow the money to compound faster because taxes are deferred until the stock is sold. For nontaxable investors, it really doesn’t matter that much, and many will reinvest dividends into buying more stock shares.
Companies are lax to cut dividends, so many investors see dividends as a signal of corporate stability.
So one question is whether or not to give cash back to shareholders or retain it for company growth. That depends on whether there are projects with NPV > 0 to invest in (or IRR > ROE). If so, then retain the cash, otherwise distribute it.
Once the decision to distribute it is made, then the real question seems to be why do dividends versus stock buybacks. Buybacks would seem to be preferred except if the company thinks its stock is overvalued. However, once a dividend is established, there is additional pressure to keep it growing.
For retirees, dividend income is nice because it can throw off cash from your investments without requiring you to sell the stock. Particularly at a time when fixed income is yielding very low amounts, dividends can be thought of as a kind of coupon payment that can grow over time.
 
No one here has given you the correct answer. They went into great detail about what dividends are, etc. That was not the question. The incentive of paying dividends rather than holding all the money in RE when you have nothing to invest in that year, in order to jump on an opportunity that may or may not exist in the future is quite simple.
There are many Federal tax rules designed to prevent people from abusing the tax system. Provisions related to these taxes are often complex. Such rules include:
Accumulated earnings tax on corporation accumulations in excess of business needs,
Those are taxed, that is the incentive to pay out the dividends. You can’t just store money, there are penalties associated with not distributing money that should be distributed in the current fiscal year.
 
BTW Chad I didn’t get to your post or maybe a few others. This may have been covered but the first 6-7 responses were just a bunch of beating around the bush that totally avoid the question. In regards to other posts Chad is very intelligible and likely cover this, unfortunately I am pressed for time right now.
 
The accumulated earnings tax may be a decent reason to distribute dividends but there are some pretty easy ways to get around it and the IRS hasn’t been pursuing it very much in the last few years. It’s definitely not as big a factor in paying dividends as many of the other reasons mentioned above. What company has been hit with this in the past few years? You just say that you are planning on acquiring MSFT and building a war chest for the hostile acquisition. In 3 years when the IRS gets around to questioning you on it, you give them a consultant’s report that says MSFT is too big for you to acquire.
Another reason that was not mentioned is that accumulated cash raises equity but produces no significant return so it hurts a company’s ROE. Since ROE is an important metric for evaluating a company, there are significant incentives to distribute excess income.
 
@Yassarian22: I agree that the question wasn’t directly answered, but at the very least it’s provided some interesting discussion around the topic. I do appreciate you chiming in as well.
In my downtime waiting for L1 results, I’m trying to avoid the material, but I’ve still been reading the forums trying to get a further understanding of the material, since I find this stuff very interesting and am not just trying to get the 3 letters after my name.
 
I do like this discussion..what we need is a place to organize this type of questions and discussions and keep adding to it. it would make good flash cards when we get closer to the exam. any takers?
 
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