Geraldine Weiss has been one of the first to recognize that dividends show that a company is fundamentally in order. She preferred dividends over profits, because it’s much harder to “adjust” dividends than profits. While talking about paying dividends and dividend she mentioned :
“can’t fake it can’t easily lower it”.
Companies with a long history of paying dividends have in general a positive free cash flow. More money is coming in than going out. The company is able to fulfill all its liabilities, paying invoices, salaries and taxes. It shows that it has a good management. One of Warren Buffets prime investment criteria’s! It shows the company is not the next new best thing…., instead it shows stability and most of the times growth.
Once a company starts paying dividends shareholders will expect to receive it on a regular base. It also shows the confidence of the management in the future profits of the company. Paying dividends also show that the companies financial processes are in order and gives more credibility to the reported earnings. However when dividends are being eliminated or lowered investors trust will be “damaged” and lowered or eliminated dividends show poor performance of the company’s management.
Another subject which has been important item in the last few years has been corporate governance. This is caused by the many earnings-management related scandals. Dividends functions as a corporate governance “bridge” between investors and the companies managers, where the companies managers can’t fake dividend payments. This shows investors that manager are “taking care” of the company and not themselves at the expense of the company. Which has been the case in the Enron scandal.
Last but not least companies which are paying dividends are (free) cash flow orientated, meaning they are managing their money very strict. The dividends force them to be more focused on how they spend shareholders money, which makes the management of companies which are paying dividends more accountable to investors.