Payment of Dividends Companies Pay

Payment of Dividends

Companies pay out dividends for a few different reasons. The first is that the income stream helps to attract investors. Theoretically, the value of a company's stock is the net present value of all future cash flows, and dividends are those cash flows. In practice, investors also seek capital gains, but the income stream from dividends remains attractive in that it provides a degree of certainty with regards to the future cash flows.

The degree of certainty is provided by the fact that dividends are often viewed as a measure of a company's financial and operational stability. A company typically only decides to pay dividends once it achieves stability. Moreover, once a dividend is set, companies are reticent to decrease that dividend because such a move will cause the stock value to fall, reducing the firm's attractiveness to investors. So not only does the presence of a dividend indicate a degree of stability, but dividend growth does as well; and a decline in dividends is viewed as being indicative of financial trouble.

There are also reasons why a company would not pay dividends. Some firms are in inherently unstable industries, or ones with a high degree of cyclicality. Cash flows may be erratic, or lacking in proven stability. As a result, the company feels that a dividend payout would burden their cash flow.

Another reason for not declaring a dividend is that a company may feel their shareholders will get better return on their investments if the company takes the money they would otherwise spend on a dividend payout and reinvests it into their operations. Firms that are rapidly growing often take this view. Other firms that take this view may have seen their growth slow but they still have new markets that they wish to develop before committing their cash flow to a dividend payout. Such growth companies give their shareholders returns by growing the equity in the company, which makes the cash payout less important.

There are different ways in which a company can pay out a dividend. One way is a residual dividend, in which the dividend paid out is made from whatever monies are left over after all operations, including the undertaking of new capital projects. This results in a relatively unstable dividend stream, since there is no certainty that money will be available.

A more common way is to have a stable dividend, where the value of the dividend is relatively fixed. It is not officially fixed, as the dividend amount needs to be declared each time before it is paid, but because of the negative connotations of decreasing the dividend, the amount is unlikely to decrease. It can, however, increase, as the company becomes more comfortable with its cash position.

Other companies choose a hybrid approach, wherein the stable component of the dividend payout is relatively low, such that the firm can easily maintain it, and then the remaining dividend component is considered to be residual. This method is popular amongst firms in cyclical industries, as it allows them to curtail dividends during down cycles and reward their investors handsomely during up cycles.

The market analyzes stocks based on their returns, of which dividends are just one components. Dividend policy is considered to be a measure of a company's financial health, and a function of its business situation. The dividend is not considered important for investors in growth stocks, who view the company's business opportunities as being lucrative enough that free cash should be reinvested rather than paid out. Conversely, high dividend stocks, known as "widows and orphans" are considered to be companies in mature industries with steady income streams. The market's view is that there is little to be gained for such companies to reinvest their earnings. Because of this, the opportunity for capital gains is limited, and investors will require the certainty of a dividend payment to justify investing.

If dividend policy is viewed in certain ways by the market, for management it is viewed as a way to send signals to the market. An increase in dividend, for example, shows confidence on the part of management in the firm's future cash flows. This is especially true for companies that are declaring their first dividends - this is management's way of signaling that the company is maturing and has arrived at a stable place in the business world.