According to finance theory, stock-market investors should be indifferent to whether they receive their returns as cash dividends or capital gains. In fact, when dividends are tax disadvantaged, as was the case until 2003 and may be so again soon, investors should prefer retention and the resulting capital gains. This led economists -- notably Fischer Black in 1976 -- to describe the payment of dividends as a puzzle. If dividends were puzzling in 1976, they are even more so today because companies can now return cash to stockholders using stock repurchases, which have at least two advantages over dividends.

First, some argue that dividends provide important “signals” about the strength or quality of the firm’s underlying earnings stream. (Because investors know that a significant dividend is a very strong commitment to paying out at least the current dividend amount on a continuing basis.) Second, dividends help discipline managers’ tendency to squander their firms’ cash on wasteful or unproductive projects or acquisitions. This is particularly a problem in large, mature companies that generate sizable free cash flow. Third, it could be that companies are catering to certain investors, who have a strong preference for dividends over capital gains.

Source: Bloomberg

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