Dividend puzzle

The dividend puzzle, as originally framed by Fischer Black, ^[1] relates to two interrelated questions in corporate finance and financial economics: why do corporations pay dividends; and why do investors "pay attention" to dividends?

A key observation here, is that companies that pay dividends are rewarded by investors with higher valuations (in fact, there are several dividend valuation models; see The Theory of Investment Value ). What is puzzling, however, is that it should not matter to investors whether a firm pays dividends or not: ^[2] as an owner of the firm, the investor should be indifferent as to receiving dividends or having these re-invested in the business; see Modigliani–Miller theorem. A further and related observation is that these dividends attract a higher tax rate as compared, e.g., to capital gains from the firm repurchasing shares as an alternative payout policy. For other considerations, see dividend policy and Pecking order theory.

A range of explanations is provided. ^{[3] [2]}

• The long-term holders of these stocks are typically institutional investors. These (often) have a need for the liquidity provided by dividends; further, many, such as pension funds, are tax-exempt. (See Clientele effect.)
• From the signalling perspective, ^[4] cash dividends are "a useful device" to convey insider information about corporate performance to outsiders, and thereby reduce information asymmetry; see Dividend signaling hypothesis.
• Behavioral economics posits that for investors, outcomes received with certainty are overweighed relative to uncertain outcomes; see Prospect theory. Thus here, respectively, investors will prefer (and pay for) certain cash dividends, as opposed to reinvestment in the firm with possible consequent price appreciation.
• Under Agency theory, ^[5] dividend policy is seen as a way to mitigate the principal–agent problem: by paying out a portion of free cash flow as dividends, shareholders (principals) can limit the actions available to managers (agents, who might otherwise engage, e.g., in "empire building"). ^[6]

References

1. Fischer Black (1976). "The dividend puzzle," The Journal of Portfolio Management , 1976.2.2:5-8.
2. George M. Frankfurter (1999). "What is the Puzzle in “The Dividend Puzzle?,", The Journal of Investing , 8(2):76-85.
3. Kwok-Chiu Lam (2014). "The Dividend Puzzle: A Summary Review of Explanations," Journal of Finance and Investment Analysis, vol. 3, no.4, 2014, 31-37.
4. Erhan Kilincarslan (2022). "Demystifying the ‘dividend puzzle’ and making sense of government regulations in times of pandemics," lse.ac.uk
5. Staff (2025). Dividend Irrelevance: Agency Theory and the Principal Agent Relationship. fastercapital.com
6. Jensen, Michael C. (1986). "Agency costs of free cash flow, corporate finance, and takeovers". American Economic Review , 1986, vol. 76, issue 2, 323-29