Why do some firms pay dividends while others do not?
WHAT ARE STOCKS AND DIVIDENDS?
To understand why some companies pay dividends while others do not, we would need to first understand what stocks and dividends are, as well as why it is advantageous for a company to issue stocks in the first place.
A stock is a share in the company's ownership. Companies sell stocks to raise the capital needed in their operations. An investor may be one of many owners in a company, and hence own a proportionate amount of all of the company's assets and earnings. If the company goes bankrupt, the investors may receive a portion of the company's profits and assets, after creditors have received their due payments. Companies that issue stock are not required to pay interest on the money received. Nor are they required to pay back the money to shareholders. This is advantageous to companies. By buying stocks, investors hope that the shares will increase in value over time; however, this may not be a big enough draw for investors, which is why some companies also offer dividends.
THE DIFFERENT KINDS OF DIVIDENDS
The reason why companies give dividends is to distribute the company's earning to the shareholders, and is a method that some companies use to encourage investors to buy their stock. There are two main kinds of dividends:
• Cash dividends, as the name suggests, are paid to shareholders in the form of cash, either as a check or via electronic transfers. As the company transfers this wealth to shareholders, the company's share price drops by approximately the same amount as the dividend paid.
• Stock dividends, however, are distributed to shareholders in the form of additional shares of stock rather than as cash. No money changes hands. Instead, the shareholder receives an increase in the number of shares of the company. Stock dividends have no value because the price drops in order to account for the dividend. Companies may wish to distribute stock dividends instead of cash dividends in the event that the company lacks the liquid cash available to pay cash dividends.
From the investor's viewpoint, cash dividends are seen by investors as a regular income stream, together with the possibility of capital appreciation of the stock; However, the investor is required to pay federal income taxes on the amount of the dividends, hence decreasing the actual benefit received.
From the investor's viewpoint, stock dividends are beneficial as they offer the investor a choice between selling the shares from the dividend to receive cash, or keeping the shares in the hopes that the company's stock price will increase. Another benefit is that the investor typically does not pay federal income taxes on the dividend until it is sold.
Note that some stock dividends have a cash-dividend option. In this case, the investor will be required to pay taxes even if the investor decides to keep the dividend in the form of shares. In general, stock dividends (that do not have a cash-dividend option) are considered by investors to be more beneficial than cash dividends due to the flexibility offered by the former.
Dividends, regardless of whether they are in the form of cash or stock, do not increase the value of the company. They do, however, reduce the value per share.
WHY DO SOME COMPANIES HAVE A POLICY OF PAYING DIVIDENDS?
Dividend policies are guidelines that companies use to determine the amount of dividends to be distributed to shareholders, instead of keeping the retained earnings to reinvest in the company. These policies are financing decisions since a company's profits are a large source of financing that is used by the company.
Some companies believe that dividends, in particular cash dividends, are a good way for management to show their confidence in the company's financial health. In order to pay a steady stream of cash dividends, a company has to have good cash flow, and, in particular has to have the liquid cash to make regular dividend payments. Dividends can attract investors to the stock.
Companies that have historically paid dividends regularly and which decrease or eliminate dividend payments often experience a sharp drop in the stock price. This is seen by investors as a weakening of the company's financial strength, hence causing investors to dump its shares. Contrastingly, if a company that has historically paid no dividends now declares that it will start paying dividends, the company's stock price will generally increase as investors show their confidence in the company by buying its shares.
Dividend-paying stocks tend to be stable companies that can afford to pay their shareholders, and have no problems honoring other financial obligations. Note that owning dividend-paying stocks is not without its risks, as the company can stop paying dividends at any time.
Do not assume that receiving a dividend is always better for the investor. Stockholders of companies with good growth prospects are sometimes better off reinvesting the profits back into the business for maximum long-term growth, and foregoing the dividends. If a company is paying too much in dividends and not investing enough in its future, it can lose market share. This will result in decreased profits and a decreased dividend payout.
WHY DO SOME COMPANIES HAVE A POLICY OF PAYING NO DIVIDENDS?
Management at some companies feel that investors who want a steady income stream can invest in other vehicles such as bonds. Because the interest payments of bonds are constant, the investor can receive a more stable source of income than that offered by cash dividends or stock dividends.
Management at some companies feel that by not paying shareholders any dividends, the company can use its retained earnings on increasing the company's profitability through research and development, expansion, or other business strategies. This can increase the value of the company as a whole, and, in turn, increase the stocks' market value. Common ways that a company uses the money that it would otherwise have paid out in dividends include having more projects, stock repurchase (which increases the stock's value for the remaining investors), mergers and acquisitions, and financial investments. Note that some debt contracts may limit the fraction of earnings ...
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