Complete Guide To Corporate Finance

Dividends - Introduction To Dividends

When a company earns profits from operations, management can do one of two things with those profits. It can choose to retain them - essentially reinvesting them into the company with the hope of creating more profits and thus further stock appreciation. The alternative is to distribute a portion of the profits to shareholders in the form of dividends. Management can also opt to repurchase some of its own shares - a move that would also benefit shareholders.

A company must keep growing at an above-average pace to justify reinvesting in itself rather than paying a dividend. Generally speaking, when a company's growth slows, its stock won't climb as much, and dividends will be necessary to keep shareholders around. This growth slowdown happens to virtually all companies after they attain a large market capitalization. A company will simply reach a size at which it no longer has the potential to grow at annual rates of 30-40% like a small cap, regardless of how much money is plowed back into it. At a certain point, the law of large numbers makes a mega-cap company and growth rates that outperform the market an impossible combination.
In this section, we'll take a deeper look at the different types of dividends and the mechanics of dividend payments; how companies establish dividend policy and the different types of dividend policies; the reasons why companies and investors might prefer higher, lower or no dividend payments; and share repurchases, stock splits and stock dividends as an alternative to cash dividends.



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