Why Pay Dividends?

Date Added: July 19th, 2004

By Chris Stallman  |  E-mail

Why do some companies pay dividends and others don’t?

-Jill K. Idaho

That’s a great question, Jill.  As you probably know, investors can earn a return on their investment through either dividends or capital gains .  So it’s important to know what affects dividends to get a sense of what kind of return you’ll earn from a stock.

A company has an opportunity to pay its investors a dividend only after it has become profitable and can generate free cash flow .  Free cash flow is the amount of cash a company generates from minus its capital expenditures.  Basically, free cash flow is the amount of cash a company has left after it’s made the necessary investments back into its business .

Free cash flow gives a company a lot of options .  They have the option of using this excess cash to either invest it back into their business or pay it out as dividends.  Sometimes companies will be trying to grow a new area of their business and they’ll want to plow their cash back into the business because they think they could get a strong return on their investments.  Or sometimes companies won’t have new areas to invest in and they feel that by paying a dividend, their shareholders can earn a better return on that cash than they can earn for them.  This is why you typically see low-growth companies paying high dividends.

It’s important to note that just because a company is highly profitable, it doesn’t mean it has the capability to pay out a big dividend.  Take Home Depot for example.  During the 1990’s, Home Depot had a strong net income but they weren’t generating much free cash flow because they opted to use most of their operating cash to build new stores and expand into new markets.

Some companies flat out hate paying dividends.  One example is Microsoft.  The company is sitting on about $30 billion in cash but hasn’t found any suitable ways to put it to use.  Common thinking is that they should pay a larger dividend, but management isn’t too keen on that because of the tax consequences.  When a company pays out a dividend, the investor has to pay taxes on it.  So dividends often aren’t the best way to put your cash to use, unless you have no other option.

We hope this helped to answer your question.  Just remember: companies with strong free cash flow typically pay dividends when they feel it’s the best use of the cash.  If there’s a better opportunity out there, they’ll reinvest it.