An introduction to dividends
Companies pay dividends to shareholders from the profit they make. It’s essentially a way of rewarding them for investing in the business.
As a dividend payment is usually passed on to shareholders in the form of cash, a dividend can be described as a ‘cash dividend’.
Key takeaways:
- Cash dividends are common, but companies can also pay profits to shareholders in additional shares instead
- The dividend amount an investor receives depends on the number of shares they own
- Dividends often come with franking credits that can lower your income tax liability.
How do they work?
Under Australian law, a company’s board of directors can authorise a dividend if they are satisfied that the company:
- Has sufficient net assets
- Can still pay creditors after the dividend payment
- Is paying a dividend that is fair and reasonable.
The board will then need to decide how much to pay in dividends and when they should be paid to shareholders.
Not everyone considers paying dividends a smart move. Some investors believe reinvesting profits can increase a company’s long-term value and deliver greater shareholder benefits through a higher share price.
However, other investors favour dividends because they want certainty and prefer receiving some returns sooner in the form of income. There can also be tax benefits for shareholders where a franking credit accompanies a dividend.
A franking credit is a tax credit that can reduce a person’s assessable income and lower their tax bill.
You’ll often come across the term dividend yield. It’s a useful metric to identify stocks that pay higher dividends quickly and is calculated by dividing a company’s annual dividend by its share price. An investor seeking dividends will also look at the dividend payout ratio and dividend history of potential investments.
Dividend-paying companies
Mature companies tend to have stable sources of finance, lower debt levels, and consistent profits, so they can afford to pay dividends.
In Australia, large blue-chip companies from well-established industries such as banking and financial services, resources, and retail tend to offer higher dividends to their shareholders.
Growth companies are likely to have higher investment expenditure and fewer sources of finance, so they tend to reinvest rather than distribute profits.
Important dividend dates
You’ll need to pay attention to the following dates to ensure you qualify for dividend payment:
- Declaration date: This is when a company announces a dividend to the market. This press release will include dividend information such as the dividend amount and whether it will be a cash or share dividend. It will also declare the ex-dividend date.
- Ex-dividend date: Investors need to buy the company’s shares before this date to receive the dividend announced. This means they will be recorded on the share registry and eligible to receive the dividend.
- Record date: The date after the ex-dividend date. At 5pm on the record date, the company will close its share register to identify the shareholders eligible for the dividend payment.
- Payment date: This is when the dividend is paid to shareholders.
Impact of dividends on share prices
Leading up to the ex-dividend date, a company’s share price might rise due to higher demand from investors buying shares to qualify for the dividend.
The company’s share price will likely fall by the dividend amount on the ex-dividend date. This is because investors who buy shares are ineligible for the dividend from this point onwards.
Why do companies pay dividends?
Companies are not obliged to pay dividends. However, shareholders expect a return on their investment, and companies can deliver this through either capital gains or dividends.
Since only profitable companies can pay dividends, this signifies financial strength and stability. It can attract new investors and lift demand for a company’s shares. Hence, companies with a strong dividend history are often reluctant to reduce or stop paying dividends, as this can give the impression of financial trouble and spook investors.
Of course, how dividends are paid is just as important as why they’re paid.
While cash dividends are more common, companies sometimes pay share dividends instead. Cash dividends are usually paid by direct credit to eligible shareholders. Share dividends are paid by allocating additional shares to eligible shareholders.
There are no rules regarding how often dividends should be paid, but many ASX companies pay an interim dividend and a final dividend each year. Sometimes, a company with exceptionally strong earnings will also pay a special dividend.
Fund dividends
While dividend definitions often focus on payments made by listed companies directly to shareholders, a mutual fund will also pass on the dividends it receives from dividend-paying shares in its investment portfolio to investors. These dividends are called ‘distributions’.
Are dividends relevant?
Some analysts consider dividends irrelevant. They argue that shareholders will still benefit if profits are reinvested instead because the share price will rise.
However, given dividends and capital gains are treated differently for tax, each shareholder will likely prefer one type of return over the other.
Buying dividend-paying investments
Investors in dividend-paying shares benefit from both capital appreciation and income payments. Shares investing comes with volatility, but regular dividends can reduce that somewhat.
Most dividend-paying stocks give you a choice of how to use your dividends. You can choose to take the cash and any franking credits that you can use to lower your tax bill. Alternatively, if the company offers a dividend reinvestment plan (DRP), you can reinvest your dividends in more shares.
Investors are usually offered a discounted share price for reinvestment through a dividend reinvestment plan. Opting into a dividend reinvestment plan allows you to grow your portfolio without thinking about it. If you elect to participate in a DRP, you will still need to declare your dividend income as though you received it in cash on your tax return.
Most ASX-listed companies pay dividends in Australian dollars, although companies that make significant income offshore may pay in another currency, such as United States dollars.
Dividend investing is highly popular with Australian shareholders, with many an investor relying on the cash flow from dividends to fund their lifestyle.