Why Do Corporations Pay Dividends?

There is increasing chatter in recent years about share repurchases, dividends, corporate investment and the ideal way for firms to use capital.  But one question that economists can’t really agree on the answer to is why companies pay dividends at all?  As noted in an excellent Twitter conversation initiated by Matthew Yglesias, even great thinkers like Richard Thaler and Tyler Cowen don’t have good answers.  And even the legends in economics don’t have a concise answer as Fischer Black once noted in this research piece.

It’s a puzzle that doesn’t have a clean answer.  After all, in a perfect world you would allocate capital to entities that could perfectly maximize the return on that capital and they would do so by reinvesting funds into their own business in a way that pays off doubly for the shareholder by increasing future returns and reducing current tax burden (dividends increase current taxes while reducing potential exposure to future profits). But the real world is never as clean as theory.  And this leads me to a rather simple conclusion – shareholders demand dividends for the purpose of optionality.

In order to understand this thinking it’s useful to go back in time to the origin of dividends.  The word dividend is derived from the Latin word “dividendum” meaning “things to be divided”.  The Dutch East India Company was the first entity to issue common stock and pay a dividend on that stock.  The reason they did this was because their company was divided among different owners serving different trade routes.  So, the owner of a share of DEIC was diversifying their risk across businesses, but equally important, they were diversifying their risk across time.  The payment of dividends gave the current owners access to profits and gave them the optionality of how they would be exposed to the risk of those profits over time.

The world has changed quite a bit in the last 500 years, but not by much when it comes to why corporations pay dividends.  The tax treatment has complicated the payment of dividends (which is why share repurchases have soared in popularity), but the thinking is still largely the same.  Shareholders like optionality and the payment of a dividend gives the shareholder the option to increase or decrease their exposure to that entity across time.  Again, share repurchases provide much the same optionality (perhaps in a superior manner depending on the taxes), but as the old saying goes, a bird in the hand is worth two in the bush.