A company that is successfully generating free cash flow can do several things with it:
- Invest internally (research & development) or externally (mergers & acquisitions), to grow the company.
- Pay down debt, which many companies have already done since the recent financial crisis.
- Buy back stock.
- Initiate or increase dividends.
Therefore, by investing in companies that pay a dividend, shareholders not only receive income from a quarterly cash payment, we believe they are also typically investing in quality companies that have the potential to grow profits. Dividends provide a source of income for many people seeking to supplement their earned or retirement income.
Most American companies that pay dividends pay them quarterly. Unlike many foreign companies that will change their dividend payments based on current levels of profitability, American companies try to maintain the amount of dividends they pay unless they face severe economic distress, as many banks did during the financial crisis of 2008.
Federal tax policy has an impact on the amount of dividends that corporations are willing to pay. If taxes on dividends are meaningfully higher than taxes on capital gains, investors prefer to invest in stocks that increase in value rather than those that pay dividends at the expense of growth. When dividends and capital gains taxes are more nearly equal, dividends become more attractive since they are less subject to volatility and provide a return even if stock prices don’t rise.
In today’s low interest rate environment, with CDs and Treasury securities paying very little, dividend paying stocks are looking increasingly attractive to many looking for current income.