Why do companies pay dividends?
It’s a good question. After all, dividends reduce management’s flexibility. The company can’t use the money it pays out to invest in research and development or other important internal items. Indeed, a Presidential Commission identified dividends paid as a major way US companies differ from firms elsewhere in the world.
Also, dividends are taxed twice. Companies pay corporate taxes on their earnings, then pay dividends out of earnings. Investors then have to pay income taxes on those same dividends when they receive them. So dividends aren’t very tax-efficient.
But dividends are an admission by the company that the ultimate owners aren’t the managers, they’re the shareholders. Paying dividends gives the owners the option to put the money back into the firm or to do something else with the money. It gives investors more choices. It also eliminates the opportunity for management to do something stupid with that money.
Dividends are totally transparent. Of the many items in a corporation’s financial statements, dividends are the one number that can’t be fudged. Since management is usually highly reluctant to cut them except in extreme situations, they often indicate financial strength as well.
Dividends are a good indicator of a company’s commitment to its current shareholders, in spite of the tax code. It’s no wonder that companies with big, safe dividends often perform quite well.
Douglas R. Tengdin, CFA
Chief Investment Officer
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