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Imagine a mature company, which has stable earnings and made a profit this year. The company is planing to pay out a part of this earnings to its shareholders. Assuming the stock price goes down exactly what is paid out per share the shareholders wealth doesn't change.

Now a few weeks later the company decides to start a new project, for which it needs to borrow money (because it paid out its excess returns) and therefore pay some interest for this borrowed money. Even when it would not do any investments it could lend the excess money to someone else and earn a little interest on that.

When the company doesn't pay a dividend the money stays within the company and therefore the company is worth more, which will be reflected in the share price (assuming efficient markets). So when the shareholders need money they could sell some of their (higher priced) stocks.

As we see from the example above the company can either choose to pay out the money and earn nothing, or keep the money and use it for investments or earn some interest on it. The company has an (opportunity) cost by paying out dividends, and is therefore not the optimal choice to do so.

Also if we assume that the increase in the share price is generally taxed as a capital gain, and capital gains are often taxed at a lower rate than income in the case of dividends.

So my question is: Why does it make sense, from a economically rational point of view, assuming both the company and also the investors want to maximize the shareholders value, to pay out a dividend?

lukstei
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    But markets are not efficient! Also, only long term capital gains are taxed less (asset held longer than 12 months). And most good compaies do invest part of their earnings, not all of it goes to dividends. – Victor Feb 07 '16 at 20:18
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    @Victor thats why I said assuming efficient markets – lukstei Feb 07 '16 at 20:57
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    But if markets are not efficient there is no reason to assume they are. Then you are not talking about reality. – Victor Feb 07 '16 at 22:39
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    You proceed from an invalid assumption. Markets are not efficient, and investors are irrational. If this question is purely theoretical then it is off topic and should be closed. Here is actual data regarding the relationship between the price of a stock and the dividend it pays. If anything, the price of the stock went down because the manager lowered the dividend. But look at the history and you will see that it is a myth that the price of the stock goes down by the value of the dividend paid. http://stockcharts.com/h-sc/ui?s=PHK&p=D&yr=2&mn=0&dy=0&id=p50779231336 – Jack Swayze Sr Feb 08 '16 at 03:37
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    REITs have to pay out a percentage of their net income to maintain their tax status that is a special case but one worth noting here as taxes aren't mentioned at all yet could be a reason for some companies to pay dividends. – JB King Feb 08 '16 at 05:34
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    Because there are basically two reasons to buy stock in a company: either you expect the stock price to go up, or you expect it to pay dividends. Since many people & institutions buy primarily for the second reason, their purchases increase demand, and so the stock price. – jamesqf Feb 08 '16 at 05:36
  • Does the stock price necessarily go down when a company issues a dividend? I don't see why this should be the case -- the stock price is what the market will support. (This is different from mutual funds, where distributions do come straight out of net asset value.) – hBy2Py Feb 09 '16 at 17:15
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    @Brian the stock price usually does go down after the company issues a dividend, due to people purchasing a stock prior to the ex-dividend date and then selling it, hopefully at a price higher than the difference between the purchase price and the dividend (and any associated transaction fees) thus making an easy few bucks. Whether it goes down more or less than the dividend varies per company, as does the timeframe of the share price decrease. It's not universal, but it's expected. – Jason Feb 09 '16 at 22:25
  • @Jason Gotcha, thanks. Is it directly tied to the actual outflow of value represented by the dividend in any fashion other than market effects? That is, is there some sort of explicit markdown made by the company, the SEC, or by the exchange on which it's traded? – hBy2Py Feb 09 '16 at 23:28
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    @brian nope, all market forces at work, the stock price isn't built upon some calculation of the fundamental value of the company, so there's no means upon which to calculate a discount. Just market forces across the board. – Jason Feb 10 '16 at 02:02
  • @Jason Indeed, that's what I'd assumed. Thanks for the info! – hBy2Py Feb 10 '16 at 02:05
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    When considering how a large company is run, consider how a company you own 100% of is run. As a board of directors, they must decide how the company should be run given the interests of the shareholders. (Yes I know, solely owned companies are run very different than 11 figure multinationals... but it does give perspective to consider the extremes!) In this case, ask yourself "How can you extract value out of my own company without selling my stake in it?" Well, a dividend seems like a decent way to do that in that case... given the tax rates, it's better than income! – corsiKa Feb 10 '16 at 06:56

7 Answers7

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The main reason, as far as I can see, is that the dividends are payments with which the shareholders may do what they want.

Capital that the company has no use for does not make a significant positive return on investment, as you pointed out, yes the company could accrue interest, but that is not going to make the company large sums of cash.

While the company may be great at making shoes - maybe even the best in the world - doesn't mean they are good investors. Sure they could dabble at using their capital to invest in other equities, but they don't, because they just want to focus on making shoes.

If the dividend goes to the investors, they can do what they wish, be it reinvest in the company, or invest elsewhere. Other companies that may make good use of the capital, and create significant returns on it are one such example.

That is the rational answer, beyond that, one of the main reasons is that people like the feeling of receiving dividends - it might not be the answer you are looking for, but many people prefer companies that pay dividends for no rational reason over companies which grow their asset value.

Will
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    Actually the discipline required to pay regular dividends ensures that the company is better run - you cant use accounting tricks you pay out real $$ - see enron for an example – Pepone Feb 07 '16 at 22:17
  • But in the real world, companies buy shares from other public companies too frequently. And for that reason when a big company fails, there may be collapse on stock exchange because many other companies hold shares and their stock price is significantly affected by the "bad investment". – i486 Feb 08 '16 at 08:41
  • @i486 not sure you point is - having to buy the dog company's is an argument against index based funds. – Pepone Feb 08 '16 at 21:44
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    @Pepone There is a trick called "Pyramid scheme" or "Ponzi scheme" that allows real $$ payout, and then scam you over even harder. Some of them flew quite high. – Dorus Feb 09 '16 at 14:09
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First, you need to understand that not every investor's goals are the same. Some investors are investing for income. They want to invest in a profitable company and use the profit from the company as income. If that investor invests only in stocks that do not pay a dividend, the only way he can realize income is to sell his investment. But he can invest in companies that pay a regular dividend and use that income while keeping his investment intact.

Imagine this: Let's say I own a profitable company, and I offer to sell you part ownership in that company. However, I tell you this upfront: no matter how much profit our company makes, you will never get a penny from me. You will be getting a stock certificate - a piece of paper - and that's it. You can watch the company grow, and you can tell yourself you own it, but the only way you will personally benefit from your investment would be to sell your piece to someone else, who would also never see a penny in profit. Does that sound like a good investment?

The fact of the matter is, stocks in companies that do not distribute dividends do have value, but this value is largely based on the potential of profits/dividends at some point in the future. If a company vows never ever to pay dividends, why would anyone invest? An investment would be more of a donation (like Kickstarter) at that point.

A company that pays dividends is possibly past their growth stage. That doesn't necessarily mean that they have stopped growing altogether, but remember that an expansion project for any company does not automatically yield a good result. If a company does not have a good opportunity currently for a growth project, I as an investor would rather get a dividend than have the company blow all the profit on a ill-fated gamble.

Ben Miller
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    No idea what prompted the DV, but a +1 from me. Actually, question is borderline OT, in my opinion. – JTP - Apologise to Monica Feb 07 '16 at 21:40
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    Stocks would be valuable to another company that wants to acquire that company. – user253751 Feb 08 '16 at 07:45
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    This leaves out the potential voting power given from shares. This is not useful practically to all but the richest individuals but does have a value to someone. – Vality Feb 08 '16 at 11:41
  • So why does anyone buy Berkshire Hathaway?? It hasn't paid a dividend in over 50 years, and never will. Is it just the stock buyback, or is that Wall Street turning perceived value into real value? – krs013 Feb 08 '16 at 19:22
  • @krs013 That's a bit different. Primarily being an investment vehicle, (it might help you to refer to my answer and the many comments) here there is no one sector, activity, or risk model as such, etc, and no particular gearing ratio, other than financial, and no fixed expectation of return. What dividend then would be appropriate or expected? Further, Berkshire Hathaway's mandate is making money from investment and compound returns, so reinvestment is more important than making profit and paying dividends. Better that investors buy and sell when it's most efficient for them. – Michael Feb 10 '16 at 12:56
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Actually, share holder value is is better maximised by borrowing, and paying dividends is fairly irrelevant but a natural phase on a mature and stable company.

Company finance is generally a balance between borrowing, and money raised from shares. It should be self evident with a little thought that if not now, then in the future, a company should be able to create earnings in excess of the cost of borrowing, or it's not a very valuable company to invest in! In fact what's the point of borrowing if the cost of the interest is greater than whatever wealth is being generated? The important thing about this is that money raised from shares is more expensive than borrowing.

If a company doesn't pay dividends, and its share price goes up because of the increasing value of the business, and in your example the company is not borrowing more because of this, then the proportion of the value of the company that is based on the borrowing goes down. So, this means a higher and higher proportion of the finance of a company is provided by the more expensive share holders than the less expensive borrowing, and thus the company is actually providing LESS value to share holders than it might.

Of course, if a company doesn't pay a dividend AND borrows more, this is not true, but that's not the scenario in your question, and generally mature companies with mature earnings may as well pay dividends as they aren't on a massive expansion drive in the same way.

Now, this relative expense of share holders and borrowing is MORE true for a mature company with stable earnings, as they are less of a risk and can borrow at more favourable rates, AND such a company is LIKELY to be expanding less rapidly than a small new innovative company, so for both these reasons returning money to share holders and borrowing (or maintaining existing lending facilities) maintains a relatively more efficient financing ratio.

Of course all this means that in theory, a company should be more efficient if it has no share holders at all and borrows ALL of the money it needs. Yes. In practise though, lenders aren't so keen on that scenario, they would rather have shareholders sharing the risk, and lending a less than 100% proportion of the total of a companies finance means they are much more likely to get their money back if things go horribly wrong.

To take a small start up company by comparison, lenders will be leary of lending at all, and will certainly impose high rates if they do, or ask for guarantors, or demand security (and security is only available if there is other investment besides the loan). So this is why a small start up is likely to be much more heavily or exclusively funded by share holders.

Also the start up is likely not to pay a dividend, because for a start it's probably not making any profit, but even if it is and could pay a dividend, in this situation borrowing is unavailable or very expensive and this is a rapidly growing business that wants to keep its hands on all the cash it can to accelerate itself.

Once it starts making money of course a start up is on its way to making the transition, it becomes able to borrow money at sensible rates, it becomes bigger and more valuable on the back of the borrowing.

Another important point is that dividend income is more stable, at least for the mature companies with stable earnings of your scenario, and investors like stability. If all the income from a portfolio has to be generated by sales, what happens when there is a market crash? Suddenly the investor has to pay, where as with dividends, the company pays, at least for a while. If a company's earnings are hit by market conditions of course it's likely the dividend will eventually be cut, but short term volatility should be largely eliminated.

Michael
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  • Uhm, borrowing doesn't increase the value of a company unless it makes more money than the interest costs. Debt is negative value, not positive. – Christopher King Feb 07 '16 at 22:49
  • @PyRulez Debt (unless at risk) is usually neutral on the balance sheet actually, because the asset lent is equal to the value of the asset given in return (the debt). But yes, the point (perhaps I didn't explain it sufficiently well) is that a company must have finance to function, and the company generates wealth from it. Any finance not serving that interest is wasted. In practise a company would have a number of borrowing facilities in order to be as efficient as possible in this regard, including long term low cost loans and flexible borrowing that goes up and down a lot. – Michael Feb 07 '16 at 23:10
  • wouldn't saving up dividends serve the same function, as the OP said? – Christopher King Feb 08 '16 at 00:01
  • @PyRulez Yes and no. Unfortunately, judging from the voting status, I'm getting the impression that my answer is going over peoples heads. The key here is that borrowed money is cheaper than money invested by shareholders. It might sound weird but that's why I wrote a long answer trying to explain it. That being the case, yes money is money, so borrowing less whilst not paying dividends means eventually no debt potentially, but borrowing money; financing the company with it, and paying dividends, that means leveraging more cheap money to generate shareholder value. – Michael Feb 08 '16 at 00:12
  • @PyRulez The truth is, the root of the question (or at least the answer) lies buried deep in the world of company finance, and not personal finance. As such one might argue the question itself is off topic on money.stackexchange. This didn't even occur to me earlier when I answered, but there you go. – Michael Feb 08 '16 at 00:15
  • are you basically saying that since shareholders are investors, and therefore know how to grow money, their is a net gain if you borrow money and then give it to them, v.s. not borrowing money and not giving it to them (couldn't they just take out their own loans)? – Christopher King Feb 08 '16 at 00:24
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    @PyRulez Hmm, not quite... Normally, a company grows in value (due to profit) for a period, then pays a dividend, thus cutting back some or all of that value again. Gearing (borrowing to shareholder investment ratio) therefore remains relatively stable. As per paragraph 3 of my answer, a policy of no dividend and no borrowing leads to lower borrowing vs the 'market capital' (shares x price) of the company (called lower gearing). Lower gearing is less efficient, especially for the mature stable earnings company the OP enquires about. – Michael Feb 08 '16 at 00:38
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    Why is it bad if less of the company's money is loans v.s. assets? Isn't it a good thing to have less debt? – Christopher King Feb 08 '16 at 00:44
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    @PyRulez: Debt is cheap, basically. The market reason is that interest on debt is paid before profits are distributed to shareholders. This implies a lower risk. In fact, with the current volume of money printing all around the world, AAA-rated companies currently receive interest on their debt (!!) Not as much as Germany receives on its bonds, though. – MSalters Feb 08 '16 at 12:06
  • Yes, exactly. Debt is exceedingly cheap at the moment, but also debt is relatively cheap any (normal) time, compared to investors, for mature companies with stable earnings. – Michael Feb 08 '16 at 12:25
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    @Michael yes I also thought about that, because paying out dividends would decrease your WACC, right? And the company has to find the right mix of debt and equity, never paying out a dividend would increase equity and would therefore be costly.. – lukstei Feb 08 '16 at 13:07
  • @lukstei Exactly correct, I perhaps should have used the WACC acronym in my answer, but the trouble is the more acronyms the more and more unreadable it becomes to more people! Also one of the confusing befuddling aspects of WACC is the W, you have to weight the various aspects of the Capital, and how do you decide on the cost of equity? I just thought if I started down that road I would end up with an essay on company finance, and really my answer was long enough as it was. I laughed at JoeTaxpayer's comment on Ben Miller's answer being OT after writing mine! – Michael Feb 08 '16 at 13:15
  • @lukstei As you can appreciate once this is taken on board, there are two stories behind dividends, and they are linked. The investor, you and I say, might choose dividend or capital growth companies variably because of our preferences and relative adversity to risk and other reasons, but although investors need to get a return are an important root cause of dividends, the reason for a company actually paying them (at least vs borrowing) is only partially to do with that. It's about company financing strategy and target gearing ratios. – Michael Feb 08 '16 at 13:24
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    You need to focus on the cost of capital bit, and show why it is true. In what way is the cost of capital cheaper from borrowing from a bank than from shares? Note that this isn't always true, or nobody (rational) would ever use capital markets, and everything would be single proprietorships funded by loans: so explaining why it is true sometimes and false other times is important. – Yakk Feb 08 '16 at 16:22
  • @Yakk Paragraph 2 introduces relatively high cost of share capital vs borrowing. Paragraph 5 explains why this is true more for mature companies with stable earnings. Paragraph 8 shows why a small high growth company is more likely to not issue dividends. Regarding single proprietorships and exclusive funding by loans, paragraph 6 explains why this does not usually happen, regardless of the relative cost of shareholder of borrowed capital. – Michael Feb 08 '16 at 22:06
  • @mich You never state your blanket claim, that borrowing ismcheaper, is false. You say it is sometimes "more true" (more true than true is ... true. There is no more.). YIf borrowing is cheaper than capitol, then using capitol because borrowing is expensive makes no sense, period. Unless borrowing is sometimes more expensive than capitol, something that would make your answer make sense, yet you avoid saying. Second, you never explain why it is cheaper to borrow than get investors. You say when it is more true and less true (but never say false?!). – Yakk Feb 08 '16 at 22:52
  • Doesn't paragraph 2 state in bold that borrowing is cheaper. Is my use of the phrase "more true" really a problem? In a mathematical boolean logic sense it is nonsense, but I thought it was clear enough that in the context of an assertion that borrowing capital is cheaper than raising share holder capital, the assertion is more true for companies that can borrow at relatively cheap rates, and conversely almost infinitely less true for say a start up with no security, no revenue and no profit. – Michael Feb 09 '16 at 10:57
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Firstly, investors love dividend paying company as dividends are proof of making profit (sometimes dividend can be paid out of past profits too)

Secondly, investor cash in hand is better than potential earnings by the company by way of interest. Investor feels good to redeploy received cash (dividend) on their own

Thirdly, in some countries dividend are tax free income as tax on dividends has already been paid. As average tax on dividend is lower than maximum marginal tax; for some investor it generates extra post tax income

Fourthly, dividend pay out ratio of most companies don't exceed 30% of available fund for paying (surplus cash) so it is seen as best of both the world

Lastly, I trust by instinct a regular dividend paying company more than not paying one in same sector of industry

Dheer
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Arun Ohri
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It comes down to the practical value of paying dividends. The investor can continually receive a stream of income without selling shares of the stock. If the stock did not pay a dividend and wanted continual income, the investor would have to continually sell shares to gain this stream of income, incurring transaction costs and increased time and effort involved with making these transactions.

James Lawruk
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The real value of a share of stock is the current cash value of all dividends the owner will receive, plus the current cash value of the final liquidation if any. Since people with different needs may judge the current cash value of an income stream differently, there would be a market basis for people to buy and sell stocks even if everyone could predict all future payouts perfectly.

If shareholders knew that a company wouldn't pay any dividends until it was liquidated in the year 2066, whereupon it would pay $2000/share, then each share would in 2016 effectively be a fifty-year zero-coupon bond with a $2000 maturity value. While some investors would be willing to trade in such an instrument, the amount of money a company could charge for such an instrument would be far lower than the money it could charge for one with payouts that were more evenly distributed through time.

Since the founders of most companies want their companies to be around for a long time, that would mean that shareholders would have no expectation of their shares ever yielding anything of value within any foreseeable timeframe. Even those who would be more interested in share-price appreciation than dividends wouldn't be able to see share prices rise if there wasn't any likelihood of the stock being bought by someone who wanted the dividends.

supercat
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Paying out dividends and financing new projects with debt also lessens the agency problem.

The consequences of a failed project are greater when debt is used, so the manager now has a greater incentive to see that the project is a success. This, in addition to the paid divided is a benefit to the shareholder. If equity wasn't paid out and instead used for the project then the manager may not be so interested in its success. And if it's a failure then the shareholders are worse off.

jigglypuff
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