Dividends typically signify good corporate management. To pay out a dividend, a company must have cash on hand. Management can’t fake it. It can (and sometimes does) fake paper profits by padding its sales and profits on reports, but it can’t fake paying cash dividends to shareholders. Paying dividends over a long period of time makes a positive statement about the company’s financial health. When you see a company paying dividends, you can expect to find confident managers in charge, exerting fiscal discipline, good corporate governance, and transparency in the company’s earnings reports:
Management confidence: Paying a dividend provides a clear signal about management’s confidence in the company’s ability to continue to post profits.
Fiscal discipline: The decision to pay a dividend isn’t entered into lightly. As soon as a company starts paying a dividend, shareholders come to expect it. Cutting or eliminating a dividend reflects very poorly on the managers and the company in the eyes of investors.
Corporate governance: Dividends provide a form of corporate governance for shareholders. Corporate managers, by the nature of their positions, know more about a company’s operations than do outside shareholders. Contemporary corporate scandals show that some managers make decisions to benefit themselves at the expense of the company and its true owners, the shareholders. Because companies can’t fake dividends, payments provide a good benchmark for shareholders.
Earnings transparency: In light of earnings-manipulation scandals, paying dividends validates the company’s accounting process and increases the credibility of the earnings reported currently and in the past. Again, you can fake sales and earnings figures, but you can’t fake cold, hard cash.
In addition, paying dividends subjects companies to certain checks and balances. Companies that pay out dividends need to be more judicious with how they spend shareholder money. They have less cash on hand to undertake corporate investments or acquisitions of other companies. Should a dividend-paying corporation decide to make a large investment or acquisition, it has to go to the capital markets, for either debt or equity, to fund the project. When companies seek outside money, investors and other interested outside parties scrutinize the plans and can often derail anything they deem foolish or overly risky. In other words, dividends make management more accountable to investors.
Public and private organizations sell either debt or equity to raise capital to fund their operations. The stock and bond markets, collectively known as the capital markets, are where capital is sold and traded.