Suppose you own a share of stock in Canada's Best Lemonade
Company. Your grandparents bought it for you when you were born, and you've
held it ever since. It's a good company. It's made money every year. Four times
a year—once a quarter—it sends you a check. At first it was 10 cents a check.
Then it went up to 11 cents and then 12 and now that you're 21 years old and
out on your own, you're making a whopping 31 cents every quarter from the
single share of stock you own.
Why?
What is a Dividend?
As explained in What is a Stock Dividend, this tiny check is
your portion of the company's profits. You own one share,so you're entitled to
that tiny percentage of whatever the company earned.
Suppose your grandparents on the other side bought you a
share of stock in Europe's Best Bagel Company when you were born, but that
company has never ever ever sent you a dividend check. It might not. It doesn't
have to. (Some companies never pay dividends.)
Why does your friendly Canadian lemonade company pay a
dividend? For any of several reasons.
A Company Might Not Have Anything Better to do with the
Money
A company can do a lot of things with its profits. It can
reinvest them in the business by expanding into new markets or geographic
areas. Perhaps it makes sense to lease retail space in malls from Prince Edward
Island to the wilds of Vancover, BC to put up lemonade kiosks, but maybe it
doesn't make sense this year (mall space is too expensive this year or the
market's currently hotter for bubble tea and lemonade would be too confusing).
Instead, the directors of the company might decide to return some of those
profits to shareholders.
A company could also decide to buy other companies with its
profits. Maybe the bubble tea fad burst and all of the bubble tea shops are
going out of business, but you could buy one of them at a huge discount and
sell bubble tea to people who really love it (the market isn't entirely going
away). Then again, maybe there are no good acquisition targets, so it makes
sense to return some of those profits to shareholders.
A company could invest the money in other financial
instruments, such as bonds or, well, other stocks. That's risky, though, and
how does the board of directors know that it'll make better investments than
shareholders could make on their own?
A Company Might Distinguish Itself By Its Dividend
To pay a dividend regularly, a company must have a
consistent business model. It can't be in the habit of losing buckets of money
every year. It has to bring in money, and it has to make a profit. If
everything else is equal, it's better to own shares of a company that reliably
makes money than a company that doesn't.
Paying a dividend reliably is a sign of strength of a
company.
A Company Might Be Attractive Only to Dividend Investors
Some people—especially retirees or people otherwise living
off of investment income—rely on quarterly dividend checks the way workers rely
on paychecks. They don't mind giving up a few points of possible returns from
companies that might have huge growth in favor of companies that grow more
slowly but always pay dividends. Paying a dividend can attract a different type
of investor, one less interested in speculation and quick turnaround. (That
might lead to less volatility of the stock's price, but that's hard to
measure.)
In this case, a truly successful company will often raise
its dividend payout regularly, as in the case of the Canadian Lemonade stock.
Sure, going from 10 cents per share to 12 cents per share over a couple of
years doesn't sound like much if you only own one share, but a company that can
return 20% more profit to its investors over a couple of years is doing
something very, very right.
A Failing Company Might Attract More Investors
There's one danger sign to look out for. A company that's
having trouble might suddenly pay out a very attractive dividend to try to
attract new investors and increase its stock price. (If the company wants to
issue more stock, this could be a mechanism to improve the expected amount of
money raised by issuing that stock.) You can spot this case pretty easily,
however: a company that's never paid much out in regular dividends suddenly
offers an attractive dividend. What's the catch?
Dividends are Nice, But They're Not Essential
Dividends aren't the only reason to hold stock. Sometimes it
makes sense for an up and coming company to invest all of its profits back into
the business. Other times it makes sense to grow by acquiring other companies.
Yet holding bushels of cash (in the case of Apple Computers, for example,
billions of dollars in reserve) makes investors wonder why they're not getting
their cut of the profits.
Investors expect their investments to grow, and the
companies they hold need to continue to make money. Whether the profits they
make get reinvested in the business or returned to shareholders as dividends,
those profits belong to the shareholders. Why do companies pay dividends?
Because the board of directors believes the best way to return this money to
the shareholders is in those nice quarterly checks.