Why Companies Pay Dividends And Why Some Others Should Do The Same

When I first started my bachelor’s degree in finance 10 years ago, I didn’t know much about dividend investing. In fact, I didn’t know much about the stock market period. In our very first finance class, we learned an important financial principal; why companies pay dividends.

But in order to understand why companies pay dividends, you must understand why investors would buy any stocks in the first place. To keep it simple, let’s say that there are only 2 things you can invest in:

#1 Certificates of Deposit with no risk issued by the Government at 3%

#2 Shares of company X

Technically, a rational investor will always look at the rewards of his investment considering what is at risk. If he takes investment option #1, he has absolutely no risk and will earn 3%. If he takes option #2, he will obviously take more risk; therefore, he will demand a higher expected return. The word “expected” is very important as it relies on the risk of the company of producing more value than the risk-free investment at 3%. So for example, the expected return of company X will be 8% which would equals to a risk-free investment of 3% plus a 5% premium for the company’s risk. Obviously, if you have sat through a finance class, the above mentioned calculation is more complicated than this but the main principle remains: a rational investor will always require a higher return from a company than from a risk-free investment.

How Companies Manage Their Money

So following financial theory, a company “receives” money from an investor in exchange for shares and is required to generate profits over 8%. Therefore, the company must invest its money in order to generate at least 8% return from its projects. This is actually one of the factors it will use before pouring money into a projects. So if we are talking about Johnson & Johnson, they will evaluate the possibility of a new product generating better than an 8% return. If we are thinking of Google, they will do the same calculations for a new online service for example.

So each time a company has surplus cash in its account, it should consider new investment projects to create more value for investors. If the company fails to produce value (at 8%), investors will gradually sell the company’s shares to buy another one and the company’s stock value will eventually drop.

Where Does the Dividend Come Into Play?

So what if the company has too much money and do not have enough valuable (giving more than 8% return) projects to invest in? This where dividends come into play. Technically, a company that can’t find enough valuable projects and has a cash surplus in its account will pay a dividend to its shareholders. Why? Because the company is giving money back to investors so he can find another place to invest his money and keep generating the 8% return he is looking for. As we agree that money markets won’t match the 8% returns, the company is logically better off giving its surplus to its investors.

Why Don’t All Companies Pay Dividends?

You are going to tell me that it is not true that some companies always have valuable projects to invest in. For example, half of Google’s assets are held in money market funds right now. They might want to consider paying a dividend? But they won’t. Some companies believe they will eventually need their liquidity to generate more yield than the expected 8% in my example. In addition to this, paying dividends is also a way to make your stock attractive to investors. So if investors already like your company (think of Google or Apple for example), there is no use in paying dividends right away as there is already a major interest for your stock anyways. By the promise of a long term growth, you are generating value to your investors and therefore, you don’t have to attract them with quarterly distributions.

Why Some Companies Should Consider Dividend Payouts

My guess is that we will see more companies starting to pay dividends or increasing their dividends as was the case in 2010. As I have mentioned before, the hunt for consistent payouts will eventually make dividend investing a bigger trend on the market during 2011. In order to get traction on the stock market and because several companies are currently holding a huge amount of cash in their bank accounts or money market funds, dividend payouts will definitely rise in 2011.

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