3 Scenarios – Why Do Companies Pay Dividends?
Why do Companies pay dividends to the shareholders? Whereas why some companies choose not to go for dividend payout? Lets see 3 scenarios of both – when companies pay dividends and when some companies don’t go for dividend payouts.
Companies pay dividends from their profits to reward their shareholders for providing them the capital to run the business. It is up to the board of directors to determine what percentage of the earnings they use to pay dividends and how much they should retain in the business.
Why Do Companies Pay Dividends?
What is a Dividend?
- A dividend is a portion of a company’s earnings that is returned to shareholders. Dividends can be issued in various forms, such as cash payment, stocks or any other form.
- Companies use dividends to pass on their profits directly to their shareholders. However, it is not obligatory for a company to pay dividend. Dividend is usually a part of the profit that the company shares with its shareholders.
- Dividends can be issued in various forms, such as cash payment, stocks or any other form. A company’s dividend is decided by its board of directors and it requires the shareholders’ approval.
- Dividends provide an added incentive (in the form of a return on your investment) to own stock in stable companies even if they are not experiencing much growth.
3 Scenarios – When Dividend Payout is Executed?
1. Lack of Enough Growth Opportunities & Future Plans
- In case, if the company perceives there are not enough growth opportunities available or if any option is not visible for making new investments, then the company would prefer distributing its profits by paying dividends to its shareholders.
- Thus, Companies use dividends to pass on their profits directly to their shareholders as an added incentive for them.
2. Consistency in Regular Cash-flows for New Investments
- For many dividend paying companies, it is not mandatory to retain the earnings from the net profits. These companies have a regular cash-flows from its business operations and there is a high consistency in their regular cash-flows.
- As a result, there is very limited or no dependency on the company’s retain earnings required for new investments or future business expansions.
3. Investors Find Dividends Paying Companies an attractive Investment
- Paying dividends sends a clear, powerful message about a company’s future prospects and performance. Company’s willingness and ability to pay steady dividends over time provides a solid demonstration of its financial strength.
- Psychologically positive sentiments are attained from investors for Dividend Paying Companies. High dividend payout is important for such investors because dividends provide certainty about the company’s financial well-being.
- Investors see a dividend payment as a sign of a company’s strength, a sign of stable company and a sign that management has positive expectations for future earnings. Such positive sentiments about the dividend paying company makes the stock more attractive. A greater demand for a company’s stock will increase its price.
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3 Scenarios – When Companies Don’t Go For Dividend Payout?
1. Re-investing the Profits
- Many a times, only moderate retained earnings are available with the company. In such case, planning to increase the company’s retained earnings becomes the foremost priority. Why retained earnings are so much important?
- Here, Retained Earnings are Re-invested in the Business Expansion instead of Paying Dividends. This is what companies with a high growth prospects do.
- Rather than paying dividends to shareholders, the management believes they can deliver better value to shareholders through capital appreciation by reinvesting the profits back into business for new products, new ideas.
2. Acquisitions for Strategic Business Expansion
- The second reason why companies will hold off on dividend payments and hoard cash is for acquisitions. This happens when one company essentially purchases another one and they merge under one entity.
- Another common occurrence is when a company will purchase an ownership stake in another company.
- Acquisitions are something that Warren Buffett is very well known for. Mr. Buffett is against paying dividends, stating that money can be spent better in other ways. He believes and also has proven that a company can deliver more value for its shareholders through reinvestment and acquisitions.
3. Limited Cash-flow in spite of Large Number of Receivables
- Many times, there are accounting entries of the expected earnings, but the actually the free cash-flow is not realised due to large number of receivables.
- In such case, there is a limited cash-flow available with the company, due to which the company is not able to pay the dividends to its shareholders in spite of visibility of the upcoming profits.
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Why Some Companies Don’t Pay Dividends?
- Expanding companies typically will not make dividend payments because during pivotal growth stages. Such companies have a high belief in their future growth prospects.
- From a fiscal point of view, it is wiser to re-invest the retained earnings into the business operations. It will enhance the overall profitability of th business and will results into rise in stock price.
- Thus, such high growing companies offer a great capital appreciation for its investors, the value of which is much more than the dividend payouts.
- Even well-established companies often re-invest their earnings, in order to fund new initiatives, acquire other companies or pay down debt. All of these activities tend to spike share price.
Key Points To Note For Retail Investors
- Retail investors should note one important point that – Dividends are nice; but they are not essential. Dividends are not the only reason to hold stock. Sometimes it makes sense for an up and coming company to invest all of its profits back into the business. Other times it makes sense to grow by acquiring other companies
- Investors expect their investments to grow, so the companies they hold need to continue to make money. Whether the profits company make get reinvested in the business or returned to shareholders as dividends, these profits belong to the shareholders.
- It can also be the case a failing company might attract more investors with high dividends. If you’re chasing the highest dividend paying stocks, watch for one danger sign. A company in financial trouble might suddenly announce out a very attractive dividend to try to attract new investors and increase its stock price. So, do a comprehensive stock analysis before entering in a new stock.
- The value of capital appreciation in the high growth and zero dividend paying stocks, is much greater than the dividends.