Why do firms pay dividends?

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Australian Economy, Macro Economics

As known widely, Dividends are the corporate earnings, which the companies pass on to the shareholders, but the question that has knocked-down many is that why they need to pay these dividends to shareholders over reinvesting the earnings into the company.

The first reason relates to “Sustainability” or “Sustainable Income” as most of the investors are interested in high dividend paying stocks because they want a steady income stream. Usually, retirees/pensioners come into this category, but nowadays, young investors also have the same mentality to earn steady income in view of their long-term goals. Since retirees don’t have a regular pay-check that’s why they always look for regular dividends that serve as steady pay-checks. Because of this, they don’t intend to sell their shares when the price is high since they bought the stocks primarily for dividend only. Of course, they want the stock price to rise in the future but the main reason why they bought the stock was to get a regular dividend stream and this leads to less fluctuation in share price. This becomes a big positive for the companies. Particularly, mature companies set the dividend benchmark as a constructive prospect relating to future earnings.

The second reason relates to, “Saturated Market”; and under this, the companies pay dividends even when the market is saturated a bit and the companies are not moving on good growth trajectory. On the other side, when there is immense potential, high growth yields higher profits and the companies opt for paying higher dividends or use the cash to invest in future growth while maintaining prior dividend trends. Thus, when the potential might not be significantly high, and the company has grown to a certain point then they pay dividends primarily to prevent share price from falling below the nominal levels.

The third point relates to “Good Investment” as most of the companies that earn profits not only just declare dividends but also, take decisions based on various facts and figures. Well, the reason why they pay heed to this is that companies don’t usually pay a dividend to give a negative impression to the investors and reflecting that the company may not be earning profits or there is any cash flow problem with the company. Thus, the companies decide to pay dividends only when they can meet all the expenses comfortably along with future expansion plans. Further, increase in dividends may not be guaranteed all the time but companies with good fundamentals try to at least maintain dividends. This reflects a healthy financial position which can prove to be a good investment. This can be related to one sector, which is mining, wherein dividends in the sector are also based on sustainability of current commodity prices. BHP Billiton (ASX: BHP) is one stock that has increased its dividends in the last two years at the back of improving performance with the recovery in commodity prices.

The next is “Low Risk” – The companies that pay dividends on regular basis are typically less risky. There are some companies that have shown false financial statements to their shareholders showing huge profits; but have barely paid the investors in cash or dividends. Hence, any company showing huge profits but not paying dividends and simultaneously not investing the idle cash in anything can be a red flag and investors like to stay away from that, although it might still be difficult to say that the company is a fraud without evaluating other aspects appropriately. At the same time, one needs to be wary of the companies that may be in financial trouble but go for higher dividend as a strategy to attract investors. Although not exactly on these lines, but Retail Food Group Limited is one stock that has been smashed a lot lately on its business model and profit downgrades which have eventually resulted to reflect a dividend yield of 33.24%, and this is linked to a significant level of uncertainty, while the stock is trying to recover a bit.

Then comes, “Recession proof”, i.e., the companies that pay regular dividends are likely to also pay in times of recession and consistency of dividend payments in hard times speaks for decent future prospects.

Eventually, investors need to be wary of the above parameters to identify the real dividend-paying gems to set a good stream of income.


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