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Why do firms pay dividends?

Ah! Dividends! Those famous checks which hit your bank account every couple of months. Investors seem to have a major crush on companies that pay dividends as they create passive income which you can easily live-off. But do you really know why most companies pay dividends?

Dividends (cash payments by the firm to their shareholders) are paid out for a number of key reasons. These include:

1)     The firm is not able to reinvest all of its earnings. When a firm is in its initial phase of growth, the company usually requires as much capital as it can get to grow the business. Companies then reinvest earnings back into the business to further grow and expand into the future. However, once companies reach maturity, this is no longer possible. An example of this would be firms such as Apple or Coca-Cola who have grown to the point that they have excess funds and don’t need all the money they have to grow the company. As a consequence these firms pay dividends.

2)     Stability: Firms who are able to pay dividends usually have stable earnings which have grown over time and continue to trend upward. The ability of a company to pay dividends usually puts a floor on its share price and provides a degree of confidence to investors who are able to identify a guaranteed yield. In low-interest rate environments, firms with a generous dividend policy are extremely well viewed.

3)     Low Capital requirements: Firms which pay out dividends are often located in industries which are not very capital intensive and do not require large amounts of ongoing investment. For example, it is easier for a firm such as Coca-Cola to pay dividends once they have established their operations compared to a business such as Amazon which is constantly required to innovate in order to seek alternative streams of growth and operates in a fiercely competitive environment.

The negative side of Dividend Payments

While the constant cash flow provided by dividends is advantageous to investors, there are a number of downsides for firms who choose to pay dividends, including.

  • The ‘Double taxation’. This refers to the fact that companies are taxed on their earnings and investors are then taxed on their dividends received. This is a ‘double tax’ when compared to capital gains tax, where only the investor is taxed. This can be avoided if you invest in certain Australian companies which allow you to ‘frank’ dividend payments.
  • Slower growth: Firms who pay dividends are usually mature companies and therefore expected to grow at a substantially slower rate than firms who do not pay dividends.

There you have it! Now you know why some companies pay dividends while others don’t.

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