Dividends represent a distribution of a company’s profits among its shareholders. They can be in the form of cash payments, additional stock or buybacks, which are usually decided by companies’ board of directors, subject to the approval of shareholders. However, paying dividends is not an obligation. In that, many companies like Amazon, Facebook and Alphabet (Google) have never paid their investors any dividends, as they choose to reinvest their profits. At the same time, companies such as Apple, Microsoft and JP Morgan have consistently paid their shareholders dividends over the years. While the process of paying dividends may just seem like a reward for investors, as a part of corporate earnings, there are actually several reasons why many companies choose to do so. Here are the most common reasons why companies pay dividends to their shareholders.

1. Reflects the financial status of the company:

The fact is that not all companies can afford to pay dividends. In that, while many companies may have losses, they may not be generating sufficient amounts of cash flows, or choose to reinvest the profits they make towards the growth of their business. Usually, when a company pays dividends to its shareholders, it is simply because they can afford to do so, and this reflects the financial longevity. A company that chooses to pay a steady dividend portrays that it has the required amount of financial strength to consistently distribute a part of its earnings to the shareholders.

2. Consistent cash flow for new investments:

For many dividend paying companies, it may not be necessary to retain their net profits to sustain their workflow. These companies may have a regular cash flow that results from their business operations, that can be directed towards making new investments and growth. 

3. Lack of other growth opportunities:

In some cases, it may be that the company does not see any viable opportunities to reinvest their profits. In the absence of such opportunities for growth, these companies choose to distribute their profits among shareholders to provide them an added incentive to maintain their returns on investments. This is usually the scenario with the more mature companies that have a larger market cap, since their growth tends to slow down in the long run once they’ve become a leading player in their industry.

4. Develops financial discipline for the company:

A dividend paying company has to be extremely efficient with the way in which it uses the surplus funds available. In that, they develop a certain discipline when it comes to handling their cash surplus. These companies are less likely to get into asset heavy projects, acquisitions and so on, which may not necessarily work in their favour. 

5. To attract more investors:

As we have noted before, dividend paying companies give off the message of stability, financial longevity and dominance in the marketplace. In that they provide strong indicators for their future performance and continued success. Taken together, these factors play an important role in attracting new investors who are looking for growth and certain regular payouts towards achieving their goals. Investors looking for a steady stream of passive income will prefer such companies that have a rich track record of consistency in paying dividends as it provides them a certainty about the company’s financial well being. 

There are several reasons why a company pays dividends to its shareholders, apart from merely being seen as a commitment or responsibility towards investors. It is good to know these underlying reasons as it helps you make a more informed choice as an investor. In that case, if you’re thinking about purchasing a dividend paying company, make sure you consult an experienced financial advisor who can help you identify the right opportunities for your portfolio and the goals you want to achieve.