Why Companies Pay Dividends

avatar By: mike
Date posted: 03.02.2011 (11:03 am) | Write a Comment  (0 Comments)

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why dividendAs an investor, the most important thing you are looking for is a good investment return. This can be achieved through:

–         Earning interest rate on CD’s or bonds

–         Earning capital gains on the sale of a stock

–         Earning dividend

One of the best combo an investor can find is to pick a top dividend stocks offering growth potential (which results into capital gains). However, not all companies pay dividend. Why some do and some don’t? let’s take a look at the following example:

Consider an investor has the option between the only 2 following investment

#1 A risk free Government bond at 3%

#2 Invest in Company X listed on the stock market.

Investors should consider 2 things; risk and potential reward. Option #1 provides a small reward (3%) but no risk. Therefore, Option #2 should provide a higher reward (3% + a premium) since there is a higher risk. This is what we call the investor expected return.

For each investment possibilities (stock, funds, bonds), the rational investor will look at what he can get without taking any risks (3% in this example) and expect a higher return if he goes for a riskier investment.

Assume the expected return of the company X is 8% (so 3% risk free + a premium of 5% for the risk). On the company side, it should invest in projects that will generate at least 8% of return. In case they have an excess of liquidity and they don’t find projects generating at least 8% return, the company should give back the exceeded money to the investor (through a dividend payout).

Why Don’t All Companies Pay Dividends?

Now that you understand why companies should pay dividend, let’s take a look at what happens in the real world. Sometimes, companies will rather keep their cash in order to prevent a cash flow shortage due to recession or they are eyeing an acquisition in the upcoming years. This is why not all company pays dividend.

When a company starts paying dividend, investors are attracted by their stocks and are more likely to buy them. On top of growth, they now offer a “steady flow of income” for the investor which some companies are able to offer. On the other side, while they are not obliged to pay dividend (they can cut their dividend at any time), holding their dividend payment will have a negative effect on the stock price. This is another reason why some companies don’t want to bother having this pressure of paying a dividend every quarter.

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