How and Why Do Companies Pay Dividends?

Look anywhere on the web, and you're bound to find information on how dividends affect stockholders. The benefits to investors include steady flows of income. However, an important part missing in many of these discussions is the purpose of dividends and why they are used by some companies and not by others. Before we begin describing the various policies that companies use to determine how much to pay their investors, let's look at different arguments for and against dividend policies.

Some financial analysts believe that the consideration of a dividend policy is irrelevant because investors have the ability to create "homemade" dividends. These analysts claim that income is achieved by investors adjusting their asset allocation in their portfolios.

For example, investors looking for a steady income stream are more likely to invest in bonds where the interest payments don't fluctuate, rather than a dividend-paying stock, where the underlying price of the stock can fluctuate. As a result, bond investors don't care about a particular company's dividend policy because their interest payments from their bond investments are fixed.

Another argument against dividends claims that little to no dividend payout is more favorable for investors. Supporters of this policy point out that taxation on a dividend is higher than on a capital gain. The argument against dividends is based on the belief that a company which reinvests funds (rather than paying them out as dividends) will increase the value of the company in the long-term and, as a result, increase the market value of the stock. According to proponents of this policy, a company's alternatives to paying out excess cash as dividends are the following: undertaking more projects, repurchasing the company's own shares, acquiring new companies and profitable assets, and reinvesting in financial assets.

Proponents of dividends point out that a high dividend payout is important for investors because dividends provide certainty about the company's financial well-being. Typically, companies that have consistently paid dividends are some of the most stable companies over the past several decades. As a result, a company that pays out a dividend attracts investors and creates demand for their stock.

Dividends are also attractive for investors looking to generate income. However, a decrease or increase in dividend distributions can affect the price of a security. The stock prices of companies that have a long-standing history of dividend payouts would be negatively affected if they reduced their dividend distributions. Conversely, companies that increased their dividend payouts or companies that instituted a new dividend policy would likely see appreciation in their stocks.

Companies that decide to pay a dividend might use one of the three methods outlined below.

Residual

Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met.

The benefits to this policy is that it allows a company to use their retained earnings or residual income to invest back into the company, or into other profitable projects before returning funds back to shareholders in the form of dividends.

As stated earlier, a company's stock price fluctuates with a rising or falling dividend. If a company's management team doesn't believe they can adhere to a strict dividend policy with consistent payouts, it might opt for the residual method. The management team is free to pursue opportunities without being constricted by a dividend policy. However, investors might demand a higher stock price relative to companies in the same industry that have more consistent dividend payouts. Another drawback to the residual method is that it can lead to inconsistent and sporadic dividend payouts resulting in volatility in the company's stock price.

Stable

Under the stable dividend policy, companies consistently pay a dividend each year regardless of earnings fluctuations. The dividend payout amount is typically determined through forecasting long-term earnings and calculating a percentage of earnings to be paid out.

Under the stable policy, companies may create a target payout ratio, which is a percentage of earnings that is to be paid to shareholders in the long-term.

The company may choose a cyclical policy that sets dividends at a fixed fraction of quarterly earnings, or it may choose a stable policy whereby quarterly dividends are set at a fraction of yearly earnings. In either case, the aim of the stability policy is to reduce uncertainty for investors and to provide them with income.

Hybrid

The final approach combines the residual and stable dividend policies. The hybrid is a popular approach for companies that pay dividends. As companies experience business cycle fluctuations, companies that use the hybrid approach establish a set dividend, which represents a relatively small portion of yearly income and can be easily maintained. In addition to the set dividend, companies can offer an extra dividend paid only when income exceeds certain benchmarks.

If a company decides to pay dividends, it will choose either the residual, stable, or hybrid policy. The policy a company chooses can impact the income stream for investors and the profitability of the company.