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I know next to nothing about finance and money, so I'm working towards becoming financially literate. I'm currently reading articles about stocks on Investopedia. An article states,

Common shares represent ownership in a company and a claim (dividends) on a portion of profits.

So it seems to me that if a company has free cash flow it should be required to pay dividends because the shareholders have a claim to their profits. Yet this is not the case. So is the statement on Investopedia incorrect or is there a catch?

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4 Answers 4

up vote 12 down vote accepted

The shareholders have a claim on the profits, but they may prefer that claim to be exercised in ways other than dividend payments. For example, they may want the company to invest all of its profits in growth, or they may want it to buy back shares to increase the value of the remaining shares, especially since dividends are generally taxed as income while an increase in the share price is generally taxed as a capital gain, and capital gains are often taxed at a lower rate than income.

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Actually, as Mitt Romney has shown, the tax rate on dividends in the US is the lowest income tax you can ever pay. But elsewhere the dividend tax situation might make more sense. –  littleadv Feb 11 '12 at 6:10
    
@littleadv That isn't actually true. Qualified dividends, which have certain restrictions, are paid at the capital gains rate, and that will not remain true if certain tax cuts aren't extended. Normally, dividends are taxed as ordinary income. –  Fomite Feb 11 '12 at 8:38
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@littleadv said "is" not "will always be." For now his statement is true. Many believe now that Romney's taxes are public and people see the impact of the favored dividend, it will chance. –  JoeTaxpayer Feb 11 '12 at 12:37
    
@JoeTaxpayer He also said "the lowest" intending to contrast it against capital gains. At best, dividends are at the same rate. "Greater than or equal to capital gains" = / = "the lowest income tax you can ever pay". –  Fomite Feb 11 '12 at 20:27
    
@EpiGrad it is the lowest, the fact that it shares the title with the long-term capital gains tax doesn't change that much:-) –  littleadv Feb 11 '12 at 22:41

Cash flow is needed for expansion, either to increase manufacturing capacity or to expand the workforce. Other times companies use it to purchase other companies. Microsoft and Google have both used their cash or stocks to purchase companies. Examples by Google include YouTube, Keyhole (Google Earth), and now part of Motorola to expand into Phones.

If you are investing for the future, you don't want a lot of dividends. They do bring tax issues. That is not a big problem if you are investing in an IRA or 401K. It is an issue if the non-tax-defered mutual fund distributes those dividends via the 1099, forcing you to address it on your taxes each year.

Some investors do like dividends, but they are looking for their investments to generate cash.

Who would require it? Would it be an SEC requirement? Even more government paperwork for companies.

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+1 - for newer companies trying to grow, forced dividends would slow that growth and potentially hurt the company. good answer. –  JoeTaxpayer Feb 11 '12 at 16:35

This answer will expand a bit on the theory. :)

A company, as an entity, represents a pile of value. Some of that is business value (the revenue stream from their products) and some of that is assets (real estate, manufacturing equipment, a patent portfolio, etc). One of those assets is cash.

If you own a share in the company, you own a share of all those assets, including the cash. In a theoretical sense, it doesn't really matter whether the company holds the cash instead of you. If the company adds an extra $1 billion to its assets, then people who buy and sell the company will think "hey, there's an extra $1 billion of cash in that company; I should be willing to pay $1 billion / shares outstanding more per share to own it than I would otherwise." Granted, you may ultimately want to turn your ownership into cash, but you can do that by selling your shares to someone else.

From a practical standpoint, though, the company doesn't benefit from holding that cash for a long time. Cash doesn't do much except sit in bank accounts and earn pathetically small amounts of interest, and if you wanted pathetic amounts of interests from your cash you wouldn't be owning shares in a company, you'd have it in a bank account yourself. Really, the company should do something with their cash. Usually that means investing it in their own business, to grow and expand that business, or to enhance profitability. Sometimes they may also purchase other companies, if they think they can turn a profit from the purchase.

Sometimes there aren't a lot of good options for what to do with that money. In that case, the company should say, "I can't effectively use this money in a way which will grow my business. You should go and invest it yourself, in whatever sort of business you think makes sense." That's when they pay a dividend. You'll see that a lot of the really big global companies are the ones paying dividends - places like Coca-Cola or Exxon-Mobil or what-have-you. They just can't put all their cash to good use, even after their growth plans.

Many people who get dividends will invest them in the stock market again - possibly purchasing shares of the same company from someone else, or possibly purchasing shares of another company. It doesn't usually make a lot of sense for the company to invest in the stock market themselves, though. Investment expertise isn't really something most companies are known for, and because a company has multiple owners they may have differing investment needs and risk tolerance. For instance, if I had a bunch of money from the stock market I'd put it in some sort of growth stock because I'm twenty-something with a lot of savings and years to go before retirement. If I were close to retirement, though, I would want it in a more stable stock, or even in bonds. If I were retired I might even spend it directly. So the company should let all its owners choose, unless they have a good business reason not to.

Sometimes companies will do share buy-backs instead of dividends, which pays money to people selling the company stock. The remaining owners benefit by reducing the number of shares outstanding, so they own more of what's left. They should only do this if they think the stock is at a fair price, or below a fair price, for the company: otherwise the remaining owners are essentially giving away cash. (This actually happens distressingly often.) On the other hand, if the company's stock is depressed but it subsequently does better than the rest of the market, then it is a very good investment. The one nice thing about share buy-backs in general is that they don't have any immediate tax implications for the company's owners: they simply own a stock which is now more valuable, and can sell it (and pay taxes on that sale) whenever they choose.

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You have plenty of good answers, but I want to add something that might help you grow your intuition on stocks. There are a lot of differences between the example I am going to give and how the stock market actually runs, but the basic concepts are the same.

Lets say your friend asks you if he can borrow some money to start up a company, in exchange you will have some ownership in this company. You have essentially just bought yourself some stock. Now as your friend starts to grow, he is doing well, but he needs more cash to buy assets in order to grow the company more. He is forced with an option, either give you some of the profits, or buy these assets sooner. You decide you don't really need the money right now, and think he can do a lot better with spending the money to buy stuff.

This is essentially the same as a company electing to not pay dividends, but instead invest into the future. You as a stock holder are fine with it since you know the money is going toward investing in the future.

Even if you never get paid a dividend, as a company grows, you can then turn around and sell the stock to someone else for more money then you gave originally.

Of course you always take the risk of having the company failing and loosing some if not all of your investment, but that is just the risk of the market.

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