Dividends 101

What is A dividend?

A Dividend is a “thank you” from the company to its investors, it is paid out of the company profits to the investors.  It is often regarded as one of the greatest ways to generate passive income. As you will receive payments into your bank account for doing no work, just financially supporting a company that pays a dividend for owning stock. 

Ultimate Guide to Dividend Stocks

 

Learn more about stocks.

Why do companies pay Dividends?

When a company generates a profit it has a few options with what it can do with the profits.

It can reinvest the profits into the company in order to generate greater returns in the future. Or it can reward investors for their financial support.

A younger company, or a company looking for growth will use their profits to reinvest into the business.

Because the business can utilise the money better by investing in itself and generate greater returns for investors in the future. 

This will usually be reflected in a high share price growth rate, think of companies like Tesla or Afterpay.

Because if either of these companies pay investors dividends when they become profitable they will go broke. 

Dividends

 

A great way to accumulate wealth and then receive passive income to live off later in life.

The other option is to use some of the profits to “thank” investors for their financial support. This is done in the form of dividend payments.

Generally companies that have been around for a long time, with stable revenue and consistent profits pay these. 

Companies like ANZ and the ANZ Dividend, that have strong balance sheets along with stable revenue and profits can comfortably use some of their profits to reward investors.

These businesses tend to pay investors instead of reinvesting in themselves. This is because it becomes a lot harder for them to innovate and generate huge growth.

Investors therefore prefer to receive payments from these companies as the share price growth rate is significantly lower than growth stocks.

These payments are a good way to generate steady income, that helps offset the lower growth rate.

Why Don’t all Companies pay dividends?

One of the main reasons is that the company has to generate a profit, in order to be able to afford to pay its investors. 

Take the recent IPO of Neobank Douugh (DOU), it hasn’t even generated any revenue yet. 

Douugh wouldn’t be able to pay a dividend as it is using investors money to launch its product in America.

It hopes to generate profit by using investors money on scaling its business model.

This leads to the next best reason why not all companies pay dividends, the company feels it can use that money in a way that will reward investors more in the future. 

Take Tesla as an example, it is using investors money to build more factories and develop their battery technology.

This should lead to greater production capacity and greater battery technology keeping their competitive advantage.

This all produces more revenue and greater returns for investors over the long-term.

Dividend Yield

 

Yield is the percentage return your investment will yield in cash payments.

Dividend Yield

A stock’s dividend yield is the percentage return your investment will yield you in regular cash payments.

It is calculated as follows:

Annual Div per share / Current Stock Price *100

Take Fortescue Metal Group, their stock price is currently (at time of writing) $20.61. They pay an annual dividend of $1.76 which gives them a yield of 8.54%. 

This dividend yield is very strong and one of the reasons investors are drawn to Fortescue Metal Group.

This is because dividend yields are currently much higher than interest rates for savings accounts, helping investors beat inflation.

Beware of the Yield Trap!

Once new investors learn about dividend yield they start looking for the highest yielding companies and then investing in them.

This would net you seriously high annual income, take for example Yancoal with a 15% dividend yield.

The trap here though, is that very high yields are generally caused from a dropping stock price and a maintained dividend. This obviously then affects the yield significantly.

Unless it is a temporary occurrence like some companies had during the peak of COVID, it is often a red flag.

If a company’s stock price drops too much, it puts a lot of financial pressure on the business.

This may mean they are unable to pay the dividend in the future. This could lead to a cut or cancelation of the dividend payment. 

It is never a smart move to invest solely in a company based on high yield. You can use it as a guiding principle, but don’t get caught investing in a struggling business. It could come back to burn you quite badly.

Dividend

 

A great form of passive income in the form of cash payments or additional stock.

Payout Ratio

Another term to understand when talking about dividends is the company’s dividend payout ratio. 

This ratio essentially tells you how much of the profits are being paid out in the form of dividends.

This is important as it helps you understand the relative security of the dividend payment.

If a company has a payout ratio of 90%, this means they are using almost all of their profits to pay their investors.

This is great for investors in the short term, but doesn’t provide much margin for error.

During the Pandemic a significant amount of Dividends were cut or cancelled.

This was due to company’s being unable to service the payments, because they had high payout ratios.

While others were to ensure some spare cash to prepare for the upcoming uncertainty. 

A business with a payout ratio of 30% is likely to have a solid dividend and be unaffected during an economic crash. This is because they have significant capital left once paying their investors.

Dividend Growth

There is often a tradeoff that occurs when deciding between investing in a growth stock or a dividend stock. 

Growth stocks tend not to pay dividends, they instead reward investors with huge capital growth. 

Dividend stocks tend to have slow capital growth and reward investors regularly with dividend payments.

The holy grail is the dividend growth stock. This happens when a company that pays its dividend increases the amount that it pays to its shareholders. 

This growth often occurs annually and only when companies have maintained their profitability.

A dividend increase is a great sign for shareholders that the board is happy with the progress of the company and that it shows their faith in the profitability of the business moving forward. 

Take Coca-Cola for example, their 10 year annual dividend growth rate is 7.3%. If their stock price didn’t increase at all in that period, that in itself would be an amazing return.

However the stock price has actually increased over 80% in that time too. That is the power of a dividend growth stock. 

Dividend Growth Curve

 

Exponential Growth Curve

Aristocrats & Kings

There are a few special companies that have been able to maintain their annual dividend increases for large periods of time. 

Companies that are a member of the S&P 500 and have increased their annual dividend payment for more than 25 years are often referred to as Dividend Aristocrats. There are 65 dividend aristocrats as of the end of 2020.

Companies that are a member of the S&P 500 and have been able to increase their annual dividend payments for more than 50 years are referred to as Dividend Kings.

There are only 30 Dividend Kings, which include companies like Coca-Cola and Johnson & Johnson.

Dividend Reinvestment plans (DRP):

Companies will often have Dividend reinvestment plans set up for their investors, this allows the investor to automatically purchase more shares of the company with their payment, rather than receiving cash.

Some companies will also provide the new issued shares at a discount to the current market value to encourage investors to elect this option.

DRP’s are a great way to visually see compounding returns occur when investing.

You literally get more shares, which pay more dividends and enable you to buy more which pay more etc..

This often leads into the question of whether you should elect to invest in the DRP or take the cash payment? 

My personal strategy is to elect into the Reinvestment Program to help accumulate more shares in the company faster.

I am in my “accumulation” phase and will be for the next 7-10years. 

After that time I will look to switch to cash payments to sustain my lifestyle and provide the financial freedom I am working towards.

But the answer to this choice will always come down to what your goals are for investing in the first place.

Reinvestment Plan

 

Reinvestment Plans help accumulate more shares over time, often at a discount to market value.

What if a dividend gets Cut?

A dividend cut is when a company either doesn’t make a dividend payment, or decreases the amount of the payment they make.

Ideally you will have done a lot of due diligence around the companies and know which ones are safer than others. But that doesn’t always protect you from a dividend cut.

Take 2020 as an example, APRA actually forced Australian banks to cut their dividends.

This was to help keep funds available for the banks so they wouldn’t be in financial trouble during the pandemic.

Essentially an enforced emergency fund from their financial governing body. This looks like it worked quite well and the restrictions have been dropped, but it goes to show even the “safest” of dividends can still get cut.

There really isn’t much you can do as the investor except if you feel a cut occurs because of poor management in which case you can vote for change.

My suggestion would be to make sure you aren’t relying 100% on the exact dividends you expect to receive.

Make sure you have a buffer in there to cover any freezes or cuts to dividend payments.

Do I pay Tax?

Yes. Dividends are assessed as a source of income so there could be a tax liability for you when receiving dividends.

In Australia dividends can also contain franking credits. This is a tax credit paid for by the company to their shareholders.

This helps eliminate double taxation, and the credits may help reduce the shareholders tax liability.

If you elect to reinvest your dividends they will still be assessed as taxable income, so don’t think you are outsmarting the taxman!

As you may end up with a big shock when tax time comes around.

Taxes

 

Taxes- They still need to be paid, even if you elect for the DRP.

Dividend Investing Strategies:

Dividend investing strategies will always come down to your investing goals and where you are in your investing journey.

Opting to invest in dividend paying companies and watching your dividends accumulate is a great way to build passive income over time.

Other people may want to see their wealth build faster through growth companies and sacrifice dividend payments now, for greater capital gains in the future.  

One thing I am keen on is passive income covering living expenses. This is a long-term goal that I will achieve via a combination of both stable dividend growth companies and investing in pure growth companies. With the view to switch that capital to passive income down the line.

Summary:

Thanks for reading and I hope you are now more informed on dividends. Are you currently receiving any? Let me know if you are, I’d love to hear from fellow investors.

Feel free to share this post with friends on social media or ask me any questions you may have. As I love helping out people with their investing and finance related questions.

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