Question

How does a company decide whether or not to pay dividends? As an investor, do you think you would prefer a company that paid a lot of dividends, or hardly any? What factors in your personal life situation would change whether you want to receive dividends? What companies did you find that do not pay dividends? Why do you think they don’t?

Answer 1

Of the many decisions a company's board of directors will need to make, one of the most important has to do with the company's dividend payout policy. If, when, and how much cash a company decides to return to owners in the form of dividends rather than share repurchases, reinvestment, debt reduction, or acquisitions has an enormous influence not only on the total return but on the type of investor who will be attracted to ownership. Dividends are corporate earnings that companies pass on to their shareholders. Dividends may be issued over various timeframes and payout rates. There are a number of reasons why a corporation may 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.

• What are the opportunities for profitable reinvestment of surplus free cash flow? If you're a firm that is expanding across the country or world with no end in sight, it doesn't make sense to pay out a dollar if you can create more than a dollar of value by putting it back to work. If you're an asset-intensive company with low returns on capital, it doesn't make a lot of sense to keep expanding. Owners would be better off paying out most of the earnings as dividends, effectively liquidating the business to some degree.
  • Generally companies in early stage of growth won’t be able to pay dividends.
  • If a company has excess cash, and few good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is GOOD. And if a company does not have excess cash, and/or has several good projects (NPV>0), returning money to stockholders (dividends or stock repurchases) is BAD.
• How stable and secure is the balance sheet and income statement? Responsible companies need to have adequate cash reserves to absorb periods of economic stress.
• What are the dividend payout policies of other companies in the same sector and industry? It can be difficult to raise capital or attract investors if you have the same economics as your peers yet you offer a much lower dividend yield.
• What type of investors does the firm want to attract? Companies that pay regular and growing dividends tend to appeal to wealthier, more stable investors. Additionally, a strong, sustainable dividend can provide an effective floor on a stock, all else being equal, due to something called dividend support; investors rushing in to buy it at the point its dividend yield becomes obscenely high, causing it to receive more bidding compared to non-dividend-paying companies when the capital markets are in a free fall. Life stage of investor also matter: If investor need cash flow requirement they prefer dividends.
• What is the particular tax law in place at the time? How are dividends treated? If dividends have a tax disadvantage; Dividends are bad, and increasing dividends will reduce value.