Companies don’t have the obligation to pay out dividends to shareholders. Therefore, it is up to the company to decide whether having dividend payments would be the right action for the business or not. There are several major companies such as Amazon (AMZN), Facebook (FB) or Alphabet (GOOGL) that have never paid any dividends to its shareholders.
While dividends may just seem like a part of corporate earnings that are being paid to the shareholders as a reward for their ownership, the act of paying a dividend often results in multiple effects and signals that can give hints about the current circumstances of the company.
Owning stocks that do pay dividends can come with significant benefits to the investor. Dividends act as an additional money stream of income but can also substantially enhance long term returns when reinvested.
Why Do Companies Pay Dividends?
But what exactly do companies intend by paying out dividends and why do some companies pay dividends while others don’t?
There are good reasons for both sites of the spectrum of why dividends might or might not be a beneficial element for the business and its shareholders. In the following, we are going to disclose some of the reasons why a company might prefer to pay dividends.
Many companies that pay dividends either do so because they are in enough financial abundance to actually afford to pay a part of earnings to please their shareholders or because they don’t see any better opportunity of reinvesting their earnings in order to grow than to simply pay out the earnings proportion as a dividend.
This is usually the case for big and mature companies since their growth tends to slow down in the long run as they become a leading role in their industry.
It wouldn’t only be more difficult but also risky to try maintaining a high-level growth in that position, so in order to attract investors and shareholders to still take part in their stable and moderate profit, they may offer a dividend as a return to their shareholders instead of high growth.
On the other hand, smaller and younger businesses that are expected to grow at a fast pace will likely refuse to pay any dividends in order to take full advantage of their earnings and to reinvest it into the company’s growth.
This shouldn’t discourage shareholders in the first place since smaller businesses that don’t pay dividends are usually expected to grow faster and thus primarily provide profit in the form of stock appreciation to investors.
The Importance of Dividends for Investors
1. Dividends Reflect the Financial Being of the Business
A company that is willing to pay a steady dividend also sets out the message that it has the required amount of financial strength to consistently distribute a part of its earnings to the shareholders.
Even if the company runs into current financial distress, by continuing to pay dividends, it indirectly communicates to investors that it still remains its positive future prospects and outlooks despite the current financial hardship.
A stable company on the other hand, that has a long-lasting history of consistent dividend payments, which suddenly cuts the dividend, will more likely bring up uncertainty and pessimism about its future financial state to the shareholders and potential investors, as the company shows that any financial support is currently needed.
Most companies that are paying consistent dividends have also proven themselves to be amongst the most stable businesses over the past decades, making them turn into blue-chip companies.
Steadily increasing dividends can signalize the confidence, experience and positive expectations by the management, which might not only encourage investors to stay within the company but to increase demand for its stock.
2. Dividends Attract More Investors
Many investors prefer to have a steady income stream from the dividends payments of a business. Additionally, there is a considerable psychological benefit that you get from constantly receiving dividend payments.
This is because dividends don’t fluctuate as opposed to the stock price and both aren’t directly correlated to each other, which automatically makes it easier for you to rather focus on the long term instead of having to worry too much about what happens in the short term.
The fact that dividends generally attract more investors can be described with a common occurrence called “yield support”.
The dividend yield of a stock is a common measure that expresses the dividend payout as a percentage rate in order to get a better view of the amount of dividend that investors would get for the current market price. In other words, the dividend yield is an assumption of the annual return that would only come from the dividend of a stock. The formula for the dividend yield goes as follows:
As an example, when company A distributes a dividend of $6 per share annually and the stock price currently sits at $200, the dividend yield of the company would be 3%.
The dividend yield is only an estimate because both the dividend payout and the stock price can always change. When the price of a stock falls, while dividends remain the same, the dividend yield will increase accordingly to the stock price decrease.
This is what some investors call “yield support” and it is the reason why strong dividend stocks usually tend to hold up better than stocks that don’t pay any dividends.
If we come back to our example stated above, company A pays an annual dividend of $6 per share and its stock is currently at $200. Its dividend yield is therefore at 3% which can already be considered attractive to many investors.
Now let’s say that company A’s stock suddenly plummets and falls 50%, meaning that the stock would now only trade at $100.
Given the fact that the business remains the same dividend of $6 per share, investors would now suddenly see a dividend yield of 6%. The increase in the dividend yield alone would attract additional investors and thus help to reduce the stock meltdown, showing that dividends play an essential role in the attractiveness of a stock.
The Significance of Dividend Returns
An investment portfolio that is solely proportioned in high yield dividend stocks can offer a considerable amount of passive income without applying any additional effort.
Additionally, history has shown that investing in stocks that paid dividends and reinvesting that dividend has brought much more significant returns than investing without reinvesting dividends.
The S&P 500 index, for instance, pays a dividend since there are a number of dividend businesses covered by the index. As a result of compound interest, reinvested dividends would make a clear difference in the overall performance in the long run. Here is a chart of the S&P 500’s performance both with and without dividends reinvested:
Source: The Motley Fool
Apart from the benefits of reinvesting dividends or using dividends for other purposes, there are also good reasons why dividends attract more investors to buy the stock and raise stock demand.
Within the stock market, the positive association with dividends is one of the primary causes for a direct stock price fall as soon as a business announces a dividend cut, or a stock price appreciation when a company chooses to increase and continue to pay dividends.
Conclusion
Dividends can be an essential component both for the investor and the company that always serves multiple purposes to both roles.
Most investors prefer to see a steady dividend from a business, as it can bring in several benefits to their overall investment return, while companies might pay out dividends as a signal of their well financial being, future prospects and admiration to the shareholders.
Quite simply, dividends serve as a great alternative way to return the company’s profits to its shareholders and are therefore paid by many major companies for good reasons.
»Learn more about why Berkshire Hathaway doesn’t pay dividends.
