Dividends are a way for a public company to increase its image of financial stability, support its stock price by attracting investors and handle certain tax strategies. In a small private company, dividends are a way to distribute the income of the company to the owners. Dividends are paid out of net earnings, so they represent a drain on company finances that could be spent on expansion instead.
Whether to pay dividends has long been a source of controversy in companies. Young companies, particularly, rarely pay dividends because their main goals normally revolve around growing the company. They generally need all the money they produce, plus outside financing, to pay for their corporate expansion activities. Normally, only mature companies that have a long history of stable earnings pay out dividends. It is considered a bad financial omen if a company is forced to lower its dividend, and a good sign if it raises its dividend.
One primary purpose of dividends is to make stockholders happy. Investors buy stock for a return on investment, either through market price appreciation or dividend income. A mature company does not have the excitement of strategic expansion and future potential to attract investors to its stock, but it is important to keep the stock price stable because it is part of a company's capitalization and aids in financing the company. If the stock price drops, the company's capitalization drops. A good dividend return tends to keep the price of a company's stock stable because it serves to attract institutional and wealthy private investors seeking stable income and tax advantages associated with dividend income.
Dividends vs. Investment
A young company attracts investors by maximizing its earning potential. This is done by investing profits back into the company. The promise of increased earnings as the company grows attracts investors who are interested in price appreciation as a return on investment. Companies only begin paying dividends when they have reached a point where there are few opportunities for beneficial investment, or they are experiencing declining stock price because of investor perception that the company has reached a point of maturity where there is little chance for exponential growth. Even the owners of a small private company would rather invest profits in growing the company to create more profits, than in paying themselves dividend distributions.
If a company has few projects and long-term stable earnings, paying out dividends is a good strategic move to enhance the financial image of the company and support its stock price. If the company has opportunities to expand business through research and development, acquisition of other companies or internal expansion activities such as marketing and the addition of new revenue streams, paying a dividend is not a good use of profits.
- World Academy Online: Dividend Policy
- Malaysian Investor: How the Dividend Policy of a Company Affects You As an Investor
- Harvard Business School; Dividend Policy inside the Multinational Firm; Mihir Desai, et al.; February 2006
- American College of Healthcare Executives: Distributions to Owners: Bonuses, Dividends, and Repurchases
- New York University, Stern School of Business: Dividend Policy
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