Earned equity has an economically more important impact on the dividend decision than do profitability or growth... firms pay dividends to mitigate the agency costs associated with the high cash/low debt capital structures that would eventually result if they did not pay dividends.
Why do firms pay dividends? In Dividend Policy, Agency Costs, and Earned Equity (NBER Working Paper No. 10599), authors Harry DeAngelo, Linda DeAngelo, and ReneStulz document that, for the 25 largest long-standing dividend payers in 2002, a decision to retain earnings instead of paying dividends would have resulted in firms with little or no long-term debt and enormous cash balances, far outstripping any reasonable estimate of their attractive investment opportunities. Had they not paid dividends, those firms would have had cash holdings of $1.8 trillion (51 percent of total assets), up from $160 billion (6 percent of assets), and $1.2 trillion in excess of their collective $600 billion in long-term debt. Paying dividends also prevented these firms from having significant agency problems -- the incremental costs and inherent conflicts of having managers make decisions for investors -- because the retention of earnings would have given managers command ove r an additional $1.6 trillion without access to better investment opportunities and with no additional monitoring.
Agency theory assumes that large-scale retention of earnings encourages behavior by managers that does not maximize shareholder value. Dividends, then, are a valuable financial tool for these firms because they help avoid asset/capital structures that give managers wide discretion to make value-reducing investments. The evidence presented in this paper uniformly and strongly supports this view of dividend policy.
This view also makes sense when one considers the rationale behind agency theory. Managers acquire control over corporate resources either from outside contributions of debt or equity capital, or from earnings retentions. From an agency perspective, one advantage of contributed capital is that it comes with additional monitoring, because rational suppliers of outside capital will not be forthcoming with funds at attractive prices if they believe that managers' policies merit low valuations.
Earned equity is not subject to the same ongoing, stringent discipline. Accordingly, potential agency problems are higher when a firm's capital is largely earned, since the more a firm is self-financed through retained earnings, the less it is subject to the ongoing discipline of capital markets.
Looking forward, firms with a greater demonstrated ability to self-finance most likely are also firms with a greater ability to internally fund projects that reduce stockholder wealth. Such potential waste is limited by ongoing distributions that reduce the cash resources under managerial control. A regular stream of dividends reduces the threat of agency problems that become increasingly serious as earned equity looms ever larger in the firm's capital structure.
For publicly traded industrials during 1973-2002, the proportion that paid dividends was high when the ratio of earned equity to total common equity (or to total assets) was high. It fell with declines in either ratio, coming close to zero when a firm had little or no earned equity. The authors consistently find a highly significant relationship between the decision to pay dividends and the ratio of earned equity to total equity (and to total assets), even after controlling for firm size, current and recent profitability, growth, leverage, cash balances, and dividend history.
The relationship between earned equity and the decision to pay dividends is significant economically as well as statistically, with the difference between high and low values of earned equity translating to a substantial difference in the probability of paying dividends. In fact, earned equity has an economically more important impact on the dividend decision than do profitability or growth, variables that are typically emphasized in the literature on empirical corporate payout. Overall, the results support the theory that firms pay dividends to mitigate the agency costs associated with the high cash/low debt capital structures that would eventually result if they did not pay dividends.
-- Les Picker
FAQs
Companies pay dividends for a variety of reasons, most often to show their financial stability and to keep or attract investors. Not all stocks pay dividends — in fact, most do not. Some major S&P 500 companies, including Amazon and Alphabet, have never issued dividends.
Why does a company pay dividends? ›
Why do companies pay dividends? Paying dividends allows companies to share their profits with shareholders, which helps to thank shareholders for their ongoing support via higher returns and to incentivise them to continue holding the stocks.
Which is the most common reason why firms pay dividends? ›
firms pay dividends to mitigate the agency costs associated with the high cash/low debt capital structures that would eventually result if they did not pay dividends.
What are the benefits of paying dividends? ›
Five of the primary reasons why dividends matter for investors include the fact they substantially increase stock investing profits, provide an extra metric for fundamental analysis, reduce overall portfolio risk, offer tax advantages, and help to preserve the purchasing power of capital.
Why do firms issue stock dividends? ›
A stock dividend may be paid out when a company wants to reward its investors but either doesn't have the spare cash or prefers to save it for other uses. The stock dividend has the advantage of rewarding shareholders without reducing the company's cash balance. However, it does increase its liabilities.
Are dividends free money? ›
Dividends are a percentage of profits that some companies pay regularly to shareholders. A dividend provides investors income, which they can reinvest if they wish. Because dividends are taken from company earnings, they limit the company's ability to invest in growth.
Are dividends good or bad for a company? ›
“Companies that have consistently increased their dividends tend to be more stable, higher quality businesses, which historically have weathered downturns and are more likely to have the ability to pay dividends consistently.”
Why doesn't Tesla pay dividends? ›
Does Tesla pay a dividend? Does it plan to? Tesla has never declared dividends on our common stock. We intend on retaining all future earnings to finance future growth and therefore, do not anticipate paying any cash dividends in the foreseeable future.
Can a company pay dividends without profit? ›
First, for a dividend to be paid, there must be profits. A general law principle states that dividends can only be paid out of retained profits. In itself, this is a rather simple test to apply.
What happens if dividends are not paid? ›
“Clause 127 — This clause corresponds to section 207 of the Companies Act, 1956 and seeks to provide that where the dividend has been declared but has not been paid or the warrants have not been posted within thirty days of declaration, every director who is knowingly party to the default shall be punishable with ...
The Risks to Dividends
9 In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks. Another downside to dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders.
Do you actually make money from dividends? ›
A quick refresher on how dividends work: Companies that earn excess profit can choose to return some of that money to their shareholders, as a sort of thank you, in the form of a regular cash payout. Some investors use these dividends as a form of income.
Does stock price drop after a dividend? ›
A stock price adjusts downward when a dividend is paid. The adjustment may not be easily observed amidst the daily price fluctuations of a typical stock, but the adjustment does happen. This adjustment is much more obvious when a company pays a "special dividend" (also known as a one-time dividend).
Why would a company ever pay dividends? ›
Dividends are corporate earnings that companies pass on to their shareholders. Paying dividends sends a message about a company's future prospects and performance. Its willingness and ability to pay steady dividends over time provides a solid demonstration of financial strength.
Why do some investors hate dividends? ›
But there is one big problem with funds that distribute dividends. What a dividend investor wants is a dividend that grows over time, and that's not usually the case with funds. They tend to adjust the dividend according to the evolution of net asset value-- the development of the market.
What is the point of dividends? ›
Companies pay dividends for a variety of reasons, most often to show their financial stability and to keep or attract investors. Not all stocks pay dividends — in fact, most do not. Some major S&P 500 companies, including Amazon and Alphabet, have never issued dividends.
What does it mean when a company gives you a dividend? ›
What Is a Dividend? A dividend is the distribution of a company's earnings to its shareholders and is determined by the company's board of directors. Dividends are often distributed quarterly and may be paid out as cash or in the form of reinvestment in additional stock.
Are dividends taxable? ›
Dividends can be classified either as ordinary or qualified. Whereas ordinary dividends are taxable as ordinary income, qualified dividends that meet certain requirements are taxed at lower capital gain rates.
How long do you have to hold a stock to get the dividend? ›
The ex-dividend date is the first day the stock trades without its dividend, thus ex-dividend. If you want to get the dividend payment, you need to own the stock by this day. That means you have to buy before the end of the day before the ex-dividend date to get the next dividend.
