Why is a stock that pays a dividend preferrable to one that doesn't?

Question

I understand that a dividend is a way for a company to return money to shareholders. But I'm not quite understanding why it is preferable to capital appreciation and putting the money to work increasing the earnings and revenue of the company. I get that people who buy stocks to get income from dividends, but the decrease in the price of a stock that correlates directly to the amount of the dividend seems to me like it's a zero-sum game.

Part of me thinks that I just fall into the Warren Buffet camp of thought that the money can be spent more wisely in house. But the other part feels like the desire for a dividend is to reinvest and add shares at a lower price (the price the stock goes to ex-dividend).

What am I missing here?

Answer 1

Check out the questions about why stock prices are what they are. In a nutshell, a stock's value is based on the future prospects of the company.

Generally speaking, if a growth company is paying a dividend, that payment is going to negatively affect the growth of the business. The smart move is to re-invest that capital and make more money. As a shareholder, you are compensated by a rising stock price.

When a stock isn't growing quickly, a dividend is a better way for a stockholder to realize value. If a gas and electric company makes a billion dollars, investing that money back into the company is not going to yield a large return. And since those types of companies don't really grow too much, the stocks typically trade in a range and don't see the type of appreciation that a growth stock will. So it makes sense to pay out the dividend to the shareholders.

Answer 2

The ultimate reason to own stock is to receive cash or cash equivalents from the underlying security. You can argue that you make money when stock is valued higher by the market, but the valuation should (though clearly not necessarily is) be based on the expected payout of the underlying security.

There are only three ways money can be returned to the shareholder:

1. Company liquidates and there is money left over after debts are paid off.
2. Company is acquired and cash or cash equivalents are given for shares outstanding.
3. Dividends

As you can see, if you don't ask for dividends, you are basically asking for one of the top two too occur - which happens in the future at the end of the company's life as an independent entity. If you think about the time value of money, money in the hand now as dividends can be worth more than the ultimate appreciation of liquidation or acquisition value. Add in uncertainty as a factor for ultimate value, and my feeling is that dividends are underpaid in today's markets.

Answer 3

One reason to prefer a dividend-paying stock is when you don't plan to reinvest the dividends. For example, if you're retired and living off the income from your investments, a dividend-paying stock can give you a relatively stable income.

Answer 4

A companies core buisiness won't keep growing forever, at least not at a pace that is compatible with stock market expectations and will soak up all the money a successful buisiness makes.

So what does a successful company do when they inevitablly run out of room for natural growth. They have a few options.

1. Just hoard the money in cash or liquid investments.
2. Spend the money on diversification and takeovers.
3. Return the money to their owners through dividends (or stock buybacks).

Option 1 isn't really doing anything that the owners could not do themselves. Option 2 means the company is essentially mixing up low-risk and high-risk activities and hence risking flushing the profits from the low-risk activities down the drain when the high-risk ones go belly-up.

Dividends are, or at least should be, a sign of stability and maturity, a sign that the company has got through the risky (but potentially very profitable) phase of fast growth and is churning out steady profits which it can return to it's owners to reinvest as they wish.

Answer 5

Dividend paying stocks are not "better" In particular shareholders will get taxed on the distribution while the company can most likely invest the money tax free in their operations. The shareholder then has the opportunity to decide when to pay the taxes when they sell their shares.

Companies pay dividends for a couple of reasons.... 1.) To signal the strength of the company. 2.) To reward the shareholders (oftentimes the executives of the firm get rather large rewards without having to sell shares they control.) 3.) If they don't have suitable investment opportunities in their field. IE they don't have anything useful to do with the money.