Why does a company pay dividends at all?

Question

If a company can lower the dividends and even stop paying them at all during hard times, why would they re-install them at all?

If I understand correctly a company pays dividends so that investors that buy stock from that company have a bigger motivation to do it and then get more people to invest in the company. But once the stock is sold and no more stock is being issued, what does the company gain by paying dividends? It seems paying dividends would only raise the price of the stock, what does a company gain by raising it? Would it make more sense to lower it and buy that back?

Answer 1

The way I think of it is that investors give a company money looking for the investment to grow.

1) Investors can invest in a fast growing, capital hungry company with the hope that the stock will go up so the investor can sell the stock and make a profit.

2) Mature companies won't generally see the same growth but could be very profitable. To balance this they can opt to offer a divided as a way to encourage investors looking for more stable investments with a steady return as upside.

At then end of the day Investors don't like seeing a pile of cash sitting in a companies bank account earning a small return. They prefer the company use the cash to generate growth or return it to investors who can then put it into another investment and hopefully make a larger return.

Dividends are a great way of returning profits to the stockholders.

Answer 2

Bill's answer is a good, but I'd like to add something specifically regarding the following part of your question:

"It seems paying dividends would only raise the price of the stock, what does a company gain by raising it? Would it make more sense to lower it and buy that back?"

I'd like to point out that the directors of a corporation owe a fiduciary duty to the shareholders of the corporation. That is, directors must generally direct the business of the corporation in a manner that is in the best interests of shareholders – all shareholders, and not some to the detriment of others.

So in theory it would benefit some shareholders for a corporation to temporarily depress its stock price to institute a buyback, but in practice if directors deliberately engineered a depressed price on purpose to buy back some of the shares, they would be in violation of the duty of care owed to all shareholders.

In reality, there are times when a corporation finds itself with a depressed stock price due to market conditions, and in those cases you do find enlightened directors instituting share buybacks. That's perfectly legal.

(BTW, here's a paper I found on the OECD web site that discusses the fiduciary duties that directors have towards shareholders: The Principal Fiduciary Duties of Boards of Directors [PDF].)

Answer 3

I think you are thinking about the investing relationship incorrectly.

Stockholders collectively own the company and also vote for the board of directors who make decisions about how much dividends to pay out.

Ultimately, they pay dividends for the same reason that a sole proprietor takes money out of his/her own company, that is, to capture a return on their investment. This is especially true for established companies that are profitable but too big or established to grow rapidly. In those situations the investors can't rely solely on the stock price growth for their return so they take it out of the profits instead of speculation on future valuations of the company.

Also, if you want to look at it from the what's-in-it-for-them perspective, consider that the compensation for the leadership of most public corporations includes a ton of company stock and stock options. So they are collecting those dividends too.

Answer 4

Also to Chris' point, if they drove down the price they could be subject to shareholder lawsuits.

When public companies buy back their stock they have to set the purchase date in the future so that it is transparent to the market. They typically say they are allocating $x to buy stock if it goes under some threshold. The main reason for doing this is the same basic logic as with a dividend, evaluating where the capital is best spent. In the case of a buyback they are saying that the capital is better invested in their own company then using it to spur growth.

Answer 5

If the directors did not pay dividends they may find the shareholders replace them with directors who do. The share price of a successful company that does not pay dividends will usually rise significantly (eg Google). In some jurisdictions it might be better from a tax standpoint to let the share price rise than pay a dividend.

Answer 6

To return profits. Remember that companies are run by people who own stock as well. They might as well pay themselves too.

(This knowledge was gained from hours of playing Railroad Tycoon)

Answer 7

Dividends are the company sending a portion of its profits to its owners (stockholders). Obviously, the amount that a company can afford to pay in dividends is related to how profitable it is. If they are consistently profitable and pay steady dividends, this will also encourage people to hold the stock for long periods, as well as for the management to strive to maintain steady profitability.

If there are no dividends, how is an investor (aka owner or stockholder) supposed to make money by owning a piece of the company? The only other way to make money as a stockholder is to sell your stock at a higher price than you bought it, either because other "investors" want it badly enough to pay more, or because some other company will try to acquire the company's stock by paying a high price for shares. This investment strategy means you are ipso facto not interested in being a long-term owner of the company, but instead are gambling on a secondary market -- that of the stock itself -- which is only loosely correlated (if at all) to the actual performance of the company.

So to answer your original question: the company may wish to encourage that kind of long-term thinking on the part of investors and management, and they may think that they are unable to make the stock price rise indefinitely, so dividends are the primary way they can encourage investment.