Why Do Firms Pay Dividends?
Dividends are cash payments made by a corporation to its stockholders. Dividend payments are a way for companies to share their profits with their owners. Dividends produce regular income, allow excess cash to be returned to the economy where it may be invested more regularly and demonstrate confidence in the firm's future earnings potential.
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Definition
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Dividends are cash payments to the stockholders of a corporation. Such payments can be made on a quarterly, semiannual or annual basis and are often announced well in advance. Dividend payments, along with the dividend distribution date, must be approved by a company's board of directors. Although dividends are usually financed by the firm's profits, there is no legal requirement for a corporation to record a profit to pay a dividend. Dividend payments may very well exceed the amount of earnings or, in rare cases, a firm may pay out a dividend even when it has lost money in the most recent financial period.
Steady Income
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Consistent dividend payments produce a predictable steam of income for shareholders. Let's assume you have $500,000 to invest in stocks and plan to finance your mortgage payments with the returns. If you purchase a non-dividend-paying stock, you must sell a portion of your stock holdings at regular intervals to make your mortgage payments. If, however, you buy a $100 stock which pays a $5 dividend per share every year, you will receive $25,000 per year regardless of what happens to the stock price in future years. This will eliminate the need to sell stock when its price may have been temporarily depressed and helps you plan your financial future with greater ease. Shares that pay regular dividends are often referred to as "income stocks" as they produce a steady stream of income.
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Excess Cash
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Another reason firms may pay out dividends is that at some point, institutions run out of potential profitable investments in their area of expertise. A toy manufacturer that has a very strong position in model cars may decide that further investment into the model car market is unlikely to produce much in the way of gains and decide to return most of its excess cash to shareholders. The alternative strategy could be to use the money to branch into dolls or action figures. Firms that pursue this later approach rarely pay much in dividends and are referred to as growth stocks.
Confidence Building
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Finally, dividend payments demonstrate a healthy and sustainable income. Companies which believe that difficult times may lie ahead rarely distribute their cash to shareholders. When one-time earnings, such as money that comes from selling an unused factory on a valuable piece of land, are the main source of earnings, dividend payments are usually low. A healthy market position, however, allows companies to share their earnings with their shareholders, since consistent profits will likely flow in. Therefore, dividends work as a message to current and future shareholders and enhance the status of the company as well as management.
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References
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