Why does a company pay dividends at all?

The way I think of it is that investors give a company money looking for the investment to grow.

1) Investors can invest in a fast growing, capital hungry company with the hope that the stock will go up so the investor can sell the stock and make a profit.

2) Mature companies won't generally see the same growth but could be very profitable. To balance this they can opt to offer a divided as a way to encourage investors looking for more stable investments with a steady return as upside.

At then end of the day Investors don't like seeing a pile of cash sitting in a companies bank account earning a small return. They prefer the company use the cash to generate growth or return it to investors who can then put it into another investment and hopefully make a larger return.

Dividends are a great way of returning profits to the stockholders.

To return profits. Remember that companies are run by people who own stock as well. They might as well pay themselves too.

(This knowledge was gained from hours of playing Railroad Tycoon)

I think you are thinking about the investing relationship incorrectly. As a partial owner of the company, you are part of "they".

Stockholders collectively own the company and also vote for the board of directors who make decisions about how much dividends to pay out.

Ultimately, they pay dividends for the same reason that a sole proprietor takes money out of his/her own company, that is, to capture a return on their investment. This is especially true for established companies that are profitable but too big or established to grow rapidly. In those situations the investors can't rely solely on the stock price growth for their return so they take it out of the profits instead of speculation on future valuations of the company.

Also, if you want to look at it from the what's-in-it-for-them perspective, consider that the compensation for the leadership of most public corporations includes a ton of company stock and stock options. So they are collecting those dividends too.

Bill's answer is a good, but I'd like to add something specifically regarding the following part of your question:

"It seems paying dividends would only raise the price of the stock, what does a company gain by raising it? Would it make more sense to lower it and buy that back?"

I'd like to point out that the directors of a corporation owe a fiduciary duty to the shareholders of the corporation. That is, directors must generally direct the business of the corporation in a manner that is in the best interests of shareholders – all shareholders, and not some to the detriment of others.

So in theory it would benefit some shareholders for a corporation to temporarily depress its stock price to institute a buyback, but in practice if directors deliberately engineered a depressed price on purpose to buy back some of the shares, they would be in violation of the duty of care owed to all shareholders.

In reality, there are times when a corporation finds itself with a depressed stock price due to market conditions, and in those cases you do find enlightened directors instituting share buybacks. That's perfectly legal.

(BTW, here's a paper I found on the OECD web site that discusses the fiduciary duties that directors have towards shareholders: The Principal Fiduciary Duties of Boards of Directors [PDF].)

Also to Chris' point, if they drove down the price they could be subject to shareholder lawsuits.

When public companies buy back their stock they have to set the purchase date in the future so that it is transparent to the market. They typically say they are allocating $x to buy stock if it goes under some threshold. The main reason for doing this is the same basic logic as with a dividend, evaluating where the capital is best spent. In the case of a buyback they are saying that the capital is better invested in their own company then using it to spur growth.

If the directors did not pay dividends they may find the shareholders replace them with directors who do. The share price of a successful company that does not pay dividends will usually rise significantly (eg Google). In some jurisdictions it might be better from a tax standpoint to let the share price rise than pay a dividend.

Dividends are the company sending a portion of its profits to its owners (stockholders). Obviously, the amount that a company can afford to pay in dividends is related to how profitable it is. If they are consistently profitable and pay steady dividends, this will also encourage people to hold the stock for long periods, as well as for the management to strive to maintain steady profitability.

If there are no dividends, how is an investor (aka owner or stockholder) supposed to make money by owning a piece of the company? The only other way to make money as a stockholder is to sell your stock at a higher price than you bought it, either because other "investors" want it badly enough to pay more, or because some other company will try to acquire the company's stock by paying a high price for shares. This investment strategy means you are ipso facto not interested in being a long-term owner of the company, but instead are gambling on a secondary market -- that of the stock itself -- which is only loosely correlated (if at all) to the actual performance of the company.

So to answer your original question: the company may wish to encourage that kind of long-term thinking on the part of investors and management, and they may think that they are unable to make the stock price rise indefinitely, so dividends are the primary way they can encourage investment.

Competition for investors. Speculative pricing notwithstanding, why would someone trade money for a stock certificate from Company A when they could invest in a stock certificate from Company B that would also pay a few percent per quarter? At the end of the (very bad trading) day, Company A will have stock (and voting rights) floating around the public priced very low, making them vulnerable perhaps to a takeover.

Already well answered, but I wanted to try a very differnt type of answer. I had a very similar confusion which use to drive me insane, so I thought I would try giving the overly-simplified answer that would have helped me better understand the relationship between dividends, shareholders, and stocks. This example is in allot of ways overly simplified, but that's sort of the point. I want to better explain what's happening using a simplified example, in reality there are more layers of indirection but conceptually this example could be said to be the root logic behind dividends and share holders that underpine it all.

First, Companies don't pay dividends to encourage people to buy their stock! Okay, that is again overly simplified, companies are aware that the dividends they pay affect stock prices and obviously consider how one will affect the other; but conceptually that's not the primary reason that dividends exist.

Instead Dividends are the way people that already own stock ask for the company to return the money it's making to them, since as owners of the company they deserve a portion of what the company makes. In a sense the "company" doesn't want to pay stocks, but it's obligated to do so because shareholders require it.

Conceptually imagine I'm starting a company (which ideally I am in 2 weeks lol). My new company has a good idea that investors are interested in, but I need more money to pay to finish the program, buy servers, and advertise it so it can get off the ground. I go to investors and offer them stocks, part of the company, in exchange for the cash i need to start my business. I did this because it's the only way to start-up, but all those people that I gave stock to want to eventually be repaid the money they gave me, with interest.

A half decade later lets say my company has grown to be worth billions. For the sake of simplicity lets say that the people i gave stocks to half a decade ago still held onto them (in reality the stocks would no doubt have been sold and resold quite a few time during this time, but effectively the logic stands even if stocks are resold, it's just a little more indirect). These people that funded me and helped me start up my company still haven't seen a penny repaid to them; and they were okay with this. They saw my company was growing and they were happy with that because the larger & faster my company grew the more it would be worth eventually, and they knew my company could grow faster if it didn't have to spend money on paying dividends. Since they now own a part of my company the more my company grows the more the can expect to get out of it later, and so are fine holding off on getting money back as long as I'm seeing good growth.

However, my company is no longer growing as rapidly as it use to be, and my shareholders are sick of holding on to there stock and waiting to be repaid. They instead come to me and say they want to start getting some money back, a way to repay their original investment. The way my company would do this is by paying dividends. Everyone that owns stock, all those who chipped in to help my company start up, now get a percentage of my income as repayment for their help starting my company.

Perhaps I would prefer for my company to keep growing, maybe I'm less interested in making lots of money as being famous for having a big company and putting my name on everything. I may not want to pay out dividends, because that money comes out of my company and means my company will not be able to grow as fast as I would like. However, I still have a responsibility to those that lent me enough money to help my company start to grow and if they want to finally get payed then I'm required to abide by my promise and pay them when they ask.

Every person that owns stock owns a part of my company, and they get to have a say in what I do with it. Effectively if 51% of the people holding stock out there all vote that I should pay dividends I have to pay dividends, because 51% of my company want me to. The company is as much theirs as mine after all, I may not get a say in the decision.

And thus I may find my company paying dividends. It isn't because I wanted it. Maybe I had already sold off 100% of my company stocks and as such I didn't even care what the stock value was, much less about raising it's value, I still am paying dividends to shareholders.

In reality these decisions aren't necessarily being made by a literal vote of shareholders. Instead the directory exists to do this, but he has a fiduciary duty to act in a way according to what the shareholders would vote. Thus he still needs to decide to pay out dividends when he feels it would benefit the shareholders the most, more indirect but still in keeping with the underlying concept above.

If a company can lower the dividends and even stop paying them at all during hard times, why would they re-install them at all?

Some companies do not pay dividends, this is usually newer tech companies and other sectors with fast growth, in these cases it is incentive enough to have a rapidly growing stock price to encourage investors to buy.

However eventually most companies reach a stage where they have grown to a fairly steady size, dividends are then used to return the profit to the investors without the company having to continue to forever grow to increase value for investors (no company can grow forever).

It seems paying dividends would only raise the price of the stock, what does a company gain by raising it?

This is backwards, paying dividends generally actually lowers stock price, this is because one of the factors in stock price is the cash holdings of the company, if they pay some of those out their value is bound to fall, with a few exceptions. A dividend is essentially the company saying they have more cash than they know what to do with (otherwise they would use the money themselves to grow), so are returning some to the investors for others use, at the cost of shrinking the company.

Would it make more sense to lower it and buy that back?

What you are touching on here is another strategy some companies use to provide value to investors without dividends, called a share buyback. This is a situation where a company buys back a proportion of their own stock from the investors, using their cash reserves to do so. This increases the share price by increasing the buy demand which benefits all investors, as well as giving money back to the investors who chose to sell their shares back to the company.

Some companies do indeed do this instead of issuing dividends, and some do a mixture of both. But it is important to remember dividends are not the -only- way of a company providing their investors with money.

This can actually have significant benefits to investors, in that those who do not wish to cash out can benefit from a stock price increase instead, without having to use a dividend reinvestment scheme, but also has some disadvantages, including causing the stock price to go up and up, potentially so high the stock becomes awkward to trade (I believe Google has had a 4 digit $ stock price in the past, before their split, which can be very inconvenient for smaller investors).

This article explains a buyback in a little more detail which may be useful to you.

This article explains how and why dividends actually decrease stock price, which should also clarify some of the misconceptions here.

Dividends today ---> increased discipline among managers tomorrow:

As Oliver Hart showed some time ago, having too much cash is bad for a firm. Then it is incentified to take on suboptimal (not very profitable) business projects, since this seems to be better than letting the cash lie around or investing it in securities without proper financial markets expertise. By reducing the cash supply, the firm ensures healthy shape among the top managers. It ensures the managers have to be careful and approve projects only with the best return-to-risk ratios. It ensures the managers do not play semi-charity.

In the described situation, the money is best used outside the firm, with investment professionals situated outside the firm. Distributing the cash surplus as a dividend ensures its most efficient use and, therefore, increases the value of cash surpluses that the firm will generate in the future.

It is also true that the top management are shareholders themselves, typically. So they do not just address their moral "duty", if any, but also maximize their investments.