Why Do Companies Pay Dividends?
Suppose you own a share of stock in Canada's Best Lemonade Company. Your grandparents bought it for you when you were born, and you've held it ever since. It's a good company. It's made money every year. Four times a year—once a quarter—it sends you a check. At first it was 10 cents a check. Then it went up to 11 cents and then 12 and now that you're 21 years old and out on your own, you're making a whopping 31 cents every quarter from the single share of stock you own.
What is a Dividend?
As explained in What is a Stock Dividend, a dividend is a portion of the company's profits that you as a stockholder are entitled to. You own one share, so you get to that tiny percentage of whatever the company earned. That's a little check sent to you every three months.
Suppose your grandparents on the other side bought you a share of stock in Europe's Best Bagel Company when you were born, but that company has never ever ever sent you a dividend check. It might not. It doesn't have to. (Some companies never pay dividends.)
Why does your friendly Canadian lemonade company pay a dividend? For any of several reasons.
Dividends are Paid Because Shareholders Have Earned that Profit
A company can do a lot of things with its profits. It can reinvest them in the business by expanding into new markets or geographic areas. Perhaps it makes sense to lease retail space in malls from Prince Edward Island to the wilds of Vancouver, BC to put up lemonade kiosks, but maybe it doesn't make sense this year (mall space is too expensive this year or the market's currently hotter for bubble tea and lemonade would be confusing).
A company could instead decide to buy other companies. Maybe the bubble tea fad burst and all of the bubble tea shops are going out of business, but you could buy one of them at a huge discount and sell bubble tea to people who really love it (the market isn't entirely going away). Then again, maybe there are no good acquisition targets.
A company could invest the money in other financial instruments, such as bonds or, well, other stocks. That's risky, though, and how does the board of directors know that it'll make better investments than shareholders could make on their own?
A company could keep the cash on hand, just in case something unexpected happens. Better to have a nest egg (can a corporation stuff a few million dollars under a mattress?) than to not.
If none of these options make sense, the board of directors might decide to return some of those profits to shareholders. That's your dividend check, right there.
Dividends are Paid by Financially Strong Companies
To pay a dividend regularly, a company must have a consistent business model. It can't be in the habit of losing buckets of money every year. It has to bring in money, and it has to make a profit. If everything else is equal, it's better to own shares of a company that reliably makes money than a company that doesn't.
Paying a dividend reliably is a sign of the business's strength. Risky businesses can't pay reliable dividends for long.
Dividends are Paid to Attract Investors
Paying a dividend can attract a different type of investor, one less interested in speculation and quick turnaround. Some people—especially retirees or people otherwise living off of investment income—rely on quarterly dividend checks the way workers rely on paychecks. These investors could perhaps make more money investing in growth stocks, not dividend stocks (dividend yield is rarely the 8% you might expect from the S&P 500 index over time), but they want the reliability of this quarterly income. (This strategy from high dividend paying stocks might lead to less volatility of the stock's price, but that's hard to measure.)
Truly successful dividend stocks often raise their payout regularly, as in the case of the Canadian Lemonade stock. Sure, going from 10 cents per share to 12 cents per share over a couple of years doesn't sound like much if you only own one share, but a company that can return 20% more profit to its investors over a couple of years is doing something very, very right (and very, very attractive). When companies pay dividends every three months and raise the amount they pay, you've found successful businesses.
A Failing Company Might Attract More Investors with High Dividends
There's one danger sign to pay attention to when chasing the highest dividend paying stocks. A company in financial trouble might suddenly announce out a very attractive dividend to try to attract new investors and increase its stock price. (If the company wants to issue more stock, this could be a mechanism to improve the expected amount of money raised by issuing that stock.) You can spot this case pretty easily, however: a company that's never paid much out suddenly offers an attractive dividend.
What's the catch? Ask yourself if you can reasonably expect to get a similar check next quarter and the quarter after that and so on. You'll avoid heartache.
Dividends are Nice, But They're Not Essential
Dividends aren't the only reason to hold stock. Sometimes it makes sense for an up and coming company to invest all of its profits back into the business. Other times it makes sense to grow by acquiring other companies. Yet holding bushels of cash (in the case of Apple Computers, for example, billions of dollars in reserve) makes investors wonder why they're not getting their cut of the profits. (See Should Apple Pay a Dividend? from before Apple announced its payout.)
Investors expect their investments to grow, so the companies they hold need to continue to make money. Whether the profits they make get reinvested in the business or returned to shareholders as dividends, those profits belong to the shareholders. Why do companies pay dividends? Because the board of directors believes the best way to return this money to the shareholders is in those nice quarterly checks.