Dividend is the term used in the context of stock markets, it refers to the distribution of earnings by profit making company to its shareholders. Dividends can be paid either in cash or by company making bonus issue or in the form of share repurchase at higher than current market price. In order to understand whether the dividends are good or not, let’s look at some of the advantages and disadvantages of dividends –
Advantages of Dividends
- The first and foremost advantage of dividend is that investors who have invested in the company become more happy and confident about the company because everybody likes to have extra when it comes to earning money and in case of stocks, dividend is the only source of income for shareholders apart from capital appreciation of stocks.
- Another advantage of dividends is that in many countries dividend income is tax free because tax is deducted at source that is on distribution of profits by company and hence when investor receives dividend he or she will not have to pay taxes on dividend income.
- Another advantage of dividend is that people who are old like to have constant source of income and if they invest in stock market they will more likely to invest in those companies which pay regular dividend rather than those company which pay irregular or no dividend and hence dividend attracts this class of investors to invest in the company.
- In stock markets a concept known as informational signaling is very important, according to this concept if company has strong balance sheet than investors would get to know about it only when company signals it by paying dividend or issuing bonus share as every investor does not have enough financial knowledge about the various financial statements and common investor will be happy only when he or she receive some benefit in the form of dividend or bonus issue.
Disadvantages of Dividends
- The biggest disadvantage of dividends is that by paying dividend company runs out of cash which could be utilized for investing into the business which in turn would have resulted in more growth for the company. In a way dividend results in sacrificing long term growth for short term benefit.
- Another disadvantage of paying dividend is that company has to pay tax on distribution of profit which would not have the case if the company had invested the amount into the business and hence in way it dividend results in additional tax burden for the company.
- If company pays dividend in 1 year and fails to pay in other years then investors worry about the future of the company and starts selling stock which results in downward pressure on the stock price and unwanted negativity about the company. Hence it is better for a company to pay stable dividends rather than erratic dividends because stock market is full of speculation and even if the financial position of company is strong and still company choose not to pay dividend then it may lead to speculation that company is in financial stress.
As one can see from the above that dividends payment has advantages as well as disadvantages and whether dividends should be paid or not is purely dependent on the financial condition of the company and also on the management future outlook abut the company.