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Why Do Stocks Pay Dividends?

I know why I love dividends. I get paid periodically for having ownership in a business. Specifically, I buy shares in a well-established company and every three months, or every month, depending on if the firm pays a quarterly or monthly dividend, I receive a paycheck.

Why do stocks pay dividends?

The premise to own dividend-paying companies is obvious, but why would companies pay out dividends? Since dividends are paid out of the firm’s earnings, don’t the firms retain less earnings by paying out dividends, and have less cash to work with?

Actually, the management of companies do not determine whether they pay a dividend or not. The board of directors of a company does. Periodically, the board reviews the dividend policy and determines if the dividend should be maintained, increased, or even cut.

Why would the board choose to pay dividends?

Reason 1: To maximize the value of each dollar spent

By paying out a portion of the earnings as dividends, there’s less money for the management of the company to work with. As a result, the management should take extra care with how the cash that’s left is used. Every dollar should be well spent.

Think about it. If you earn $10,000 per month in income versus $1,000, would you spend the money differently? I would certainly calculate my spending meticulously if I earned $1,000 every month, and only buy the essentials. When a company has less money to work with, it will go for the projects that have the highest returns and the least risk.

Reason 2: To encourage long-term investing

By paying a dividend, the board encourages income-oriented investors to buy and hold its stock. These shareholders are there mainly for the income, but appreciate steady growth, so they’re unlikely to sell for short-term trades.

Let’s use TransCanada Corporation (TSX:TRP)(NYSE:TRP) as an example. At about $47 per share, it pays a decent dividend of 4.4%, which is expected to grow by roughly 6-8% per year in the foreseeable future.

In the last few months it has gone down in price, along with the other energy companies, and the price is likely to continue further downwards in the negative sentiment. However, even if the price keeps going down, its income-oriented shareholders aren’t likely to sell because the company’s dividend remains solid.

In a downturn, it’s much easier to tolerate your holdings that are in the red if you’re receiving a growing dividend from a solid company. Other than being financially solid with an A- S&P credit rating, TransCanada has increased its annual payouts for 14 years in a row.

At the start of 2015 it continued this trend and hiked the dividend by 8.3%. Its payout ratio remains sustainable around 86% based on trailing 12-months’ earnings per share and its quarterly dividend of $0.52 per share.

Reason 3: To reduce price volatility

Companies that pay a dividend, particularly ones that pay a growing dividend, have less volatile prices. It’s not to say that their prices don’t go up or down. They do. However, its decent yield and growing dividends help stabilize its share price compared with companies that don’t pay a dividend.

In conclusion

Dividend-paying companies, particularly ones that have been paying a growing dividend for many years are profitable companies over periods of economic turmoil or growth. Dividends allow shareholders to have a positive return even in the face of declining prices, dividends help reduce stock price volatility, and they encourage long-term investing.

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Fool contributor Kay Ng has no position in any stocks mentioned.

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