Why Do Companies Pay Dividends?

Markets Motley Fool

In this edition of Industry Focus, host Michael Douglass and Fool contributor Matt Frankel discuss dividends. They agree that dividends can be important features of a stock to income investors, and an established track record of paying dividends can be an excellent way for a company to build investor confidence. In this video, Michael and Matt discuss why companies pay, and sometimes cut, their dividends.

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A full transcript follows the video.

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This video was recorded on Oct. 9, 2017.

Michael Douglass: Let's talk about dividends a little bit.

Matt Frankel: Sure. Dividends are kind of the most visible way to return capital to shareholders, which could be a good thing or a bad thing. It's a good thing if a company can pay a reasonable dividend, establish a good record of increasing their dividend payments. There's a whole group of stocks called the Dividend Aristocrats, which have all increased their dividend payments annually for at least 25 years, some much more than that. In that case, it can be kind of a selling point, in a way, for investors. Here's predictable, steady, rising income. Of course, it's not guaranteed. But it definitely looks good as an investment.

Douglass: Absolutely. By the way, if you're interested in a list of the Dividend Aristocrats, send us an email at industryfocus@fool.com, and we'll be happy to shoot you a list. Again, that's industryfocus@fool.com.

The other thing is, dividends can be attractive for income investors. Those are often retirees, or people who are looking for some minimum annual return on their investments. If it's a 2% dividend or 3% dividend, they know, barring something crazy happening, they're probably going to get paid at least that. And that can really help them from a financial planning standpoint. On the flip side, dividends often stop making sense. And that's when companies have to cut them. Essentially, as we said earlier with share buybacks and dividends, it's this realization that a company cannot spend all of its money in accretive ways to the company. So instead, they're going to do share buybacks and dividends. Well, sometimes, companies are in a spot where that's no longer the case, and they actually don't have enough cash flow to be able to grow appropriately with these sort of capital-allocation decisions they previously made.

Teva Pharmaceuticals (NYSE: TEVA) from my own healthcare is a great example. They substantially cut their dividend just a couple of months ago, specifically because they're weighed down with interest expense, they made a big acquisition, and they had so many expenses that it was hampering their growth. So cutting their dividend was the only way for them to be able to really invest in growth appropriately. Of course, the stock got creamed when that happened. I think Teva lost something like 50% of its market cap in the month of August, when it made this announcement. So it was a rough month for Teva shareholders. But on the flip side, at that point, it kind of makes sense, and you want them, I think, to cut that dividend so that they can instead grow shareholder value in other ways.

Frankel: Right. It would almost be irresponsible to keep paying it at that point. But like you said, because it's the most visible way to return capital, it's taken by shareholders as a sign of the company being unhealthy. Like you've just said, cutting the dividend was probably the healthiest thing they could have done in that situation.

Douglass: Right. Of course, it is kind of a sign of unhealthiness, too. When you can no longer meet all those commitments, it's where you're stuck.

Frankel: Definitely. It works both ways. A dividend record can either be a good thing or a bad thing. Companies need to make sure they can reasonably continue to pay a dividend if they want to implement one.

Douglass: Yeah, so much matters on context, unfortunately. That's one of the things that I think is really frustrating for a lot of investors. There aren't a lot of really simple, hard and fast rules. So much depends on the situation. That's why doing your research and really understanding companies is so important.

Matthew Frankel has no position in any of the stocks mentioned. Michael Douglass has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.