Friday, November 21, 2008

Why should companies pay out dividends?

In theory it makes sense for companies to reinvest all of their earnings straight back into the business, compounding the growth rate of the enterprise to achieve a higher asset base. If a company can put their earnings to good use, there is no reason for them to pay fat dividends.

In reality however the money is wasted away on failed acquisitions, taking on too much risk with new products. Companies that consistently not only pay but increase their dividends over time are more fiscally responsible than the companies that don't pay any dividends.

Companies that reward shareholders with dividends are showing confidence in their ability to generate growing earnings because they could afford to. Furthermore companies paying out dividends show shareholders those earnings are real and not manufactured by an army of CPA's.
As a small business owner myself, I enjoy getting cash back from my businesses on a regular schedule so that I could decide if I wanted to reinvest into the business by purchasing more shares or spend it on something else.

Last but not least most companies can only grow their ROE/ROA so much as they could be reaching the limits of their marketplace. The ROE would then incrementally start declining, making it worthwhile for these stocks to pay out dividends instead of spending the cash on acquisitions to buy competitors or start a division in a completely new sector in order to diversify. More often than not branching out into different industries does not work.

Microsoft has been a recent stock which has initiated and closely followed a dividend growth strategy over the past five years. Cisco Systems also recently announced that it was seriously considering paying a dividend to its stockholders.

According to Ned Davis Research, dividend paying stocks have also outperformed non dividend paying stocks over the past 35 years.

To summarize it is nice for companies to pay out some portion of earnings (up to mid 50%) back and then reinvest the rest in the business. Long term success comes from good balancing of the owners’, management and enterprise interests.

Relevant Articles:

- How low can Dow go?
- My Dividend Growth Plan - Strategy
- When to sell your dividend stocks? Part 2
- Diversification and portfolio allocation
- The friendliest states for dividend investors

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