Why Do Companies Pay Dividend?

A listed company will definitely want to attract more investors to buy their stock, push up the share prices, and to collect more money for growth and expansion. One way to attract investors is to pay investors with dividends, where investors will receive them in a form of passive income.

Another reason is that company might have very good earnings, but left with excessive cash idling and no plan to use the money. It will then opt to pay it back to investors.

Then you might wonder, why don’t the company keep the cash for future use? Here’s the thing, if investor feel that the company has too much cash and it is not putting it to use. The investors might feel that the company has reached it terminal growth, and he/she will most likely sell its stock. If more investors see things the same way and sell the stock, the share price will drop significantly. That is not a nice picture that the company wish to see.

Dividend Yield

So at what rate will the companies be paying the dividends? The rate of return of dividend is measured in terms of yield. The formula is by using Annual Dividend per Share, and divided by current stock price.

Let’s look at example below:

Current Stock Price of ABC company = $10
Annual dividend per share = $0.50
Dividend yield –> 0.5/10 * 100 = 5%

If you have bought 1500 share, the dividend you will receive per year:
–> 1500 * $10 * 5 / 100 = $750

If the stock price gone up by 10% after one year and you sold it, your total returns will be 15%!

However do be very careful with companies that give very high dividend pay-out. A good company should be giving out less than 100% dividend pay-out, so that it can utilized the left over cash for future growth plan.

How do you calculate dividend pay-out ratio? The formula is by using annual dividend per share divided by earnings per share.

Earnings per share are derived by using (Net Income – Dividends on Preferred Stock) / Average Outstanding Share.

Sounds too difficult? Not to worry, whenever a company announced earning, earnings per share can be obtained by various financial website who released the news of the company. Just do a search on the company using the search engine.

A company who has high dividend pay-out ratio, its share price tends to grow less aggressively, as investors may see it as there is not much growth in future. However, it also depends on the business nature of the company, a company might have high dividend pay-out ratio, yet investor might see it has potential for growth for other reasons.

Also, be very careful with companies who has very high dividend yield (at the range to 15% or above), why? Well, because when things look too good to be true, they are too good to be true. You really need to read the financial statements inside out and figure out why.

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