When a publicly traded company earns a profit, it has the option of of sharing its profits with its shareholders through the payments of cash dividends. Many companies whose shares trade in the stock market pay dividends to investors. There are advantages and disadvantages to both the corporation and investors concerning the payment of cash dividends.
TL;DR (Too Long; Didn't Read)
While cash dividends do provide a certain degree of incentive and reward to investors, they can also slow corporate growth. With that in mind, taking the time to understand the advantages and disadvantages of paying cash dividends is critical.
Corporate Profit Options
A corporation has three basic choices of what to do with net profits or cash flow. One is to reinvest the money back into the business to generate growth and larger profits in the future. A second option is to buy back shares, with the intention of boosting its share value. The third option is to pay out some of the profits to shareholders in the form of cash dividends. Dividend payments are the most direct way to put company profits into the hands of the shareholders.
Corporate Advantages and Disadvantages
A major advantage of paying dividends is that they can help provide shareholder loyalty. Companies with a history of dividend payments are expected to maintain those payouts if possible. The major disadvantage of paying dividends is the cash paid out to investors cannot be used to grow the business. If a company can grow its sales and profits, the share value will increase, as investors are attracted to the stock. A company that pays too high a portion of profits as dividends has little money to fund growth and the share value will not increase.
Understanding Dividend Investors
Investors who choose stocks that pay dividends are concerned about receiving that regular income stream from a stock investment. Some companies and the associated stocks have histories of steadily increasing the dividend year after year. Stocks that pay dividends usually do not exhibit rapid share price increases associated with growth stocks. When selecting stocks for investment, investors must balance receiving dividends with having the company reinvest profits for future growth.
Investor Advantages and Disadvantages
A major advantage of receiving dividends is that it's money in the bank. A stock price will go up and down over time, but once a dividend is paid, the investor has a return on his investment. Also, dividends can be used to buy additional investments. A disadvantage of receiving dividends is that the distributions received are taxable income. Investing in a stock that does not pay dividends allows an investor to defer gains until the stock is sold. Profits in stock price gains can be deferred for many years.