Why are dividends paid out?

Recently I received a dividend cheque from a company I have shares in.

What is a dividend?

Why is it paid to shareholders?

Wouldnt it be better if the company used this money to reinvest to improve the companys value rather than borrowing money? Presumably doing this would reduce interest and tax payments.

It encourages the shareholders to hang onto their shares (if lots of them sold up to make a quick buck when the price spiked, it could be a bad thing).

You invest money in a company so that in the future you will receive more money one way or another. (If you didn’t expect to get more money back, you’d be better off hiding the money under your bed, or putting it into an bank account).

There are only a few ways a company can return money to its shareholders:
(1) By winding up the company, and distributing the proceeds. Usually this is a bad idea, because the company is worth more as a going concern.
(2) By repurchasing some shares. This may or may not be a bad thing, but it reduces the capital available to run the company, and companies don’t do it very often.
(3) By paying a dividend out of the profits.

A company can only do (1) once, and it won’t do (2) very often. So the only way to give shareholders a return is to give a dividend.

Ah, but you might say that shareholders can sell their shares to someone else at a profit. That’s true, but that purchaser will also want to get a return on their investment, and they can ony get it from the company in one of the ways listed above.

Strange as it may seem, it used to be that the main reason investors bought stock was to get the dividends (which essentially is returning the net profits to the owners).

Stocks weren’t expected to appreciate all that much, and certain types of stocks – notably utilities – are still generally purchased to provide a steady income stream. You can purchase the right portfolio of electric utility stocks and get a dividend check every month (or at least you used to).

Nowadays, people buy in the expectation of appreciation, so companies plow the profits into the business in order to keep the stock price rising.

Giles is right. Just as the owner of a small business will typically use some profit to build the business, and put some of it in his own pocket, public companies retain some of their earnings and return some to the owners, the shareholders. This was once the primary reason individual shareholders bought shares, to receive dividends. New companies, or companies which are for some other reason going through a rapid period of expansion and capital investment, will often retain all of their earnings to pay for new equipment or other costs of growth. The buying back of shares that Giles mentioned is often done by companies who believe that their share price is too low, that the company is actually worth more than the market currently believes it is worth. They believe the buy-back will ultimately increase shareholder value when the stock price rises.

Many companies have alot of cash flow. It would be great if they could find high-return type projects to reinvest into. But if a project doesn’t provide a financial return higher than the shareholders’ expected return, it’s better to give the money back to the shareholders. If not, you’d reduce the company’s overall value, and the price of each share.

Additionally, paying down debt is not necessarily a good idea. Debt reduces the company’s overall cost of capital (one reason being that interest payments are tax deductible). Debt also adds value in other ways, which we won’t get into right now. Having a lower cost of capital allows companies to receive higher value on the projects in which they invest. In short, having an appropriate amount of debt adds to shareholder value, and results in a higher stock price. Modigliani and Miller won a Nobel Prize showing this (I’m simplifying this for the purpose of this discussion).

Not true. Shareholders also get a return because of the rising value of a stock.

I remember seeing a mathematical proof in one of my financial econ classes that investors in a company (in the hypothetical perfect market) would be ambivalent to whether a company paid out dividends or reinvested the profits in the company because ultimately their return would be the same. I’m pretty sure this was a Modigliani and Miller proposition.

There’s a tax reason, too, sort of:

http://taxguide.completetax.com/text/Q10_2026.asp

If the corporation cannot justify hanging on to large sums of money without a good reason. There are plenty of ways around this rule, btw, but the corporation can’t just be a piggy bank. So this doesn’t directly answer the OP, which I take to be asking why dividends instead of some other reasonable expenditure. Nevertheless, corporate tax professionals consider this rule among other concerns when determining whether a dividend should be paid.

But, as Giles pointed out, shareholder returns from the rising value of a stock are not directly connected with the company’s business, it is dependent, fundamentally, on some third party being willing to buy your ‘stake’ in the company for a higher price than you paid for it.

So, I think one thing that confuses a lot of people about the stock market is, “Why is stock worth anything in itself, except inasmuch as it might provide a share of the company’s revenue?” (As per Giles’ three points above.)

One alternate answer I can think of is that if the company is rich and economically powerful, a share represents (at least theoretically) a tiny piece of leverage to control how that company uses its economic power to interact with other economic players. That is something that could be valuable, at least, in the hands of someone who is capable of using it. If I owned 15 shares of microsoft, I might not know what to do with the voting rights myself, but I could, theoretically, sell to someone who already owned a lot more stock. That’s one reason that my shares have value.

Can anyone else shed more light on the question?? Do I need to explain further what’s confusing me about value stocks as opposed to dividend stocks??

Last year Microsoft paid out a one-time $3.00 per share dividend. Why? They had a bit too much cash on hand that they couldn’t find a good use for: $56 billion.

First of all, “Value” stocks are generally dividend-paying stocks while “Growth” stocks generally don’t pay dividends. If a company is in a mature industry, say Newspapers, it probably produces a good amount of cash flow. It sells advertising to advertisers as well as newspapers to subscribers. It probably has too much cash coming in to handle. So what does it do with the cash? Well, it can invest in new projects. But there’s probably not too much room to grow. There’s only a limited subscriber base and there’s probably only limited room to add advertisers. So there probably are not too many projects available to it that would provide an adequate financial return. Certainly not enough of them to use up all of the cash coming in. So dividends are paid to the shareholders. The company is saying, we’re doing quite well. We don’t need all of this cash, so take some back and do something better with it.

“Growth” stocks are in industries where there is much potential for growth. These companies use all of their cash to fund their future growth. They may even hold cash to acquire other companies. Shareholders know this so they don’t expect a dividend, YET! As the growth of the company continues, it will start receiving more and more cash. As the industry matures, it will become more like the newspaper company we described above. But you say, if there are no dividends, where is the value? Why is the stock so highly priced? Well, shareholders value the company on the prediction that, eventually, the company will pay dividends. It’s the perception of when they will begin, and at which pace they will grow, that shareholders bet on. Even Microsoft had to pay a dividend recently. The irony is, once companies start paying dividends, their valuations fall. This is because implicit statement is: We don’t have much growth potential left. There aren’t many high-return projects for us to invest into. This is why we must pay a dividend. The same perception occurs when a company holds too much cash. Hence, the Microsoft dividend.

Who decides the dividend amount? Does the make up of the shareholder body influence how often dividends are payed out (e.g., would a population of holders or some mix of size or relationship to the company find they can not get dividends as the managers would rather play with the money or develop perks, like a new water fountain in the lobby?) What is a typical % of the stock’s market value that becomes dividends in, say, one of these dividend-common industries?

We’re getting into capital structure and financial strategy here. Volumes of research have been published on these subjects. In general, Management recommends a dividend amount that the Board of Directors approves. Both of these entities are supposed to be agents of the shareholders and act in the shareholders’ best interests (Enron and WorldCom be damned!). If they don’t, shareholders can vote them out. So the dividend preferences of individual shareholders should not be considered. Instead, management should make decisions to maximize overall shareholder value (which is to maximize the stock’s return).

Capital structure management (including dividend policy) is part of what I do for a living. The thing about dividends is that they are usually interpreted by the markets (analysts and shareholders) in various ways. Most mature companies like to pay consistent dividends. Once a dividend increase is announced, it is normally bad policy to reduce it the next time. This is considered a bad signal. Signalling is very important due to the asymmetry of information between management and investors (Management knows everything going on with the company, while investors only have access to public information). Let’s just say that you received a 25 cent dividend for each stock you owned in a company. Theerafter, each quarter for several years, you received the same dividend. But this time, the dividend is reduced to 15 cents. What would you think? Wouldn’t you begin to have concerns about the company’s cash flows? Perhaps you would even sell some of your shares. Instead, if the dividend is increased to 35 cents, and this continues, you may even want to buy more shares. These perceptions by the aggregate shareholder base can move the stock. It may be that reducing the dividend one time was to fund a large capital project or acquisition. In this case, you may view this as a positive move.

Dividend yields (Annual dividend divided by stock price) vary greatly. Currently, the S&P 500’s dividend yield is 1.69%.

The company’s management decides. Specifically, the board of directors.

If the shareholders are unsatisfied with dividend performance, they can replace the board of directors.

http://www.clevelandfed.org/Research/com2001/0401.htm

And see, http://faculty.insead.edu/peyer/FFE/Dividend%20US%20COMPANIES.doc (Word document)

You’re not remembering the MM proposition correctly. The mathematical proof is that investors are indifferent between $x cash dividends and the company’s using $x to repurchase shares. (The basic idea being if yuo want the cash now you can sell some or all of your shares. If you don’t you can keep your shares.) You are indiffenet between dividends or buy-back payments and a new investment only if the new investment is a break-even pospect (in the economic sense i.e., zero net present value not in the accounting sense).