The above question has probably been asked by investors for many decades, and it seems to be a key reason investors hesitate when it comes to buying shares of a company. Companies are technically not legally obligated to pay a dividend, unlike bonds issued, where the coupon payment is a contractual obligation. And yet, there are many companies that not only pay regular dividends, but some are so predictable that investors rely on them for an almost certain source of income.
Companies pay out dividends for a variety of reasons, and investors who know how to choose the right dividend-paying companies are able to enjoy an almost uninterrupted flow of passive income. Even though companies may not be obligated to pay a dividend, there are cases where management feels somewhat compelled to do so.
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I want to share a few examples of such cases and how investors can take advantage of them by including such companies in their portfolios to build up an income stream.
Signaling that the business is doing well
Many listed companies are eager to let the market know that their business is doing well, as this creates a favourable impression and also assists the company in case it needs to raise funds in a secondary offering or rights issue. Hence, a company may commit to a certain level of dividends in an announcement (e.g., 30% of after-tax profits) in order to maintain that impression.
This creates a kind of “psychological obligation” on the part of management to pay out a dividend, as they do not wish to appear as if they are performing poorly. Investors who latch on to such companies receive good assurance that dividends will be paid out since management is usually loathe to reduce them given the negative signal it would send.
Founder owns a significant chunk of shares
A company may also be obligated to pay a dividend when the founder himself owns a large chunk of the shares (e.g., 20% to 30%) and does not draw a huge salary or bonus. That means the founder’s personal cash flow consists primarily of dividends received from the business he owns. Such companies have more of an incentive to pay out dividends than a company whose owner or management owns only small stakes.
Nature of the business
In recent years, new types of business structures and entities have sprung up that promise a baseline level of dividends for investors. One example is real estate investment trusts (REITs), which need to pay out at least 90% of their profits in order to enjoy preferential tax incentives. Some listed business trusts have also specifically communicated their desire to pay out a regular dividend, though this would of course depend on the underlying health of the business.
The Foolish takeaway
While companies are not specifically required to pay a dividend (even if they are profitable), the above examples show that there are many cases where a company would commit to paying them. Investors need to look for such companies in order to enjoy a steady stream of assured dividends.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.