Question

Some types of investors prefer dividend paying stocks because dividends provide a regular, convenient source of income. Does demand from these investors necessarily lift the prices of dividend pay stocks relative to stocks of companies that pay no dividends but repurchase shares instead? Explain

Answer 1

Dividends are corporate earnings that companies pass on to their shareholders. They can be in the form of cash payments, shares of stock, or other property. Dividends may be issued over various timeframes and payout rates.

There are a number of reasons why a corporation might choose to pass some of its earnings on as dividends, and several other reasons why it might prefer to reinvest all of its earnings back into the company.

Why Some Companies Choose to Issue Dividends

For a mature company with stable earnings that doesn't need to reinvest as much in itself, here's why issuing dividends can be a good idea.

Many investors like the steady income associated with dividends, so they will be more likely to buy that company's stock.

Investors also see a dividend payment as a sign of a company's strength and a sign that management has positive expectations for future earnings, which again makes the stock more attractive. A greater demand for a company's stock will increase its price.

Companies that pay dividends include Apple (AAPL), Microsoft (MSFT), Exxon Mobil (XOM), Wells Fargo (WFC), and Verizon (VZ).

Why Some Companies Choose Not to Pay Dividends With Their Profits

A company that is still growing rapidly usually won't pay dividends, because it wants to invest as much as possible into further growth.

Even a mature firm that believes it will do a better job of increasing its value (and therefore a better job of increasing its share price) by reinvesting its earnings will choose not to pay dividends. Companies that don't pay dividends might use the money to start a new project, acquire new assets, repurchase some of their shares or even buy out another company.

The choice to not pay dividends may be more beneficial to investors from a tax perspective. Non-qualified dividends are taxable to investors as ordinary income, which means an investor's tax rate on dividends is the same as his marginal tax rate. Marginal tax rates can be as high as 37% (as of 2018). For qualified dividends, the tax rate is either 0%, 15%, or 20%, depending on the marginal income tax bracket that the investor falls under. The capital gains on the sale of appreciated stock can have a lower, long-term capital gains tax rate (typically up to 20% as of 2018) if the investor has held the stock for more than a year.

Firms that choose to reinvest all of their earnings, instead of issuing dividends, may also be thinking about the high potential expense of issuing new stock. To avoid the risk of needing to raise money this way, they choose to keep all of their earnings.

A company may also choose not to pay dividends because the decision to start paying dividends or to increase an existing dividend payment is a serious one. A company that eliminates or reduces its existing dividend payment may be viewed unfavorably and its stock price may decrease.

Notable companies that historically have not paid dividends to shareholders include Facebook (FB), Alphabet (GOOG), Amazon (AMZN), Biogen (BIIB) and Tesla (TSLA).

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