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Why shares are great investments part 2: Dividends

I think one of the best reasons to invest in shares and hold them for the long-term is the dividends that they pay to investors every year.

Last time I wrote about how shares are great for delivering returns for investors.

There’s a reason why the phrase “it pays dividends” exists. We don’t have to exert any effort for our companies to pays us dividends every quarter or half-year.

Businesses pay dividends and distributions out of the profits they make every year, as well as from the profit reserve of earnings made in previous years. Dividends are sustainable as long as profit goes up over the long-term. 

Dividends will generally follow the direction of revenue and profit. It’s quite easy for a lot of businesses to grow their profit each year. When you combine inflation and population growth, that should mean many economy-linked businesses like Wesfarmers Ltd (ASX: WES) and Transurban Group (ASX: TCL) can grow revenue organically by at least 4% to 5% each year.

Some businesses may decide to have a relatively conservative dividend payout ratio – perhaps paying out 50% or less of annual profit – so that they can re-invest the retained amount for future profit growth and hopefully higher dividends.

A lot of ASX shares have dividend yields higher than what you can get from a savings account, with income growth and capital growth potential. It’s the profit growth year after year that causes attractive compounding returns. 

There are plenty of ASX shares that have been growing their dividends for five years or more such as Brickworks Limited (ASX: BKW), Rural Funds Group (ASX: RFF), WAM Research Limited (ASX: WAX), Arena REIT No 1 (ASX: ARF), REA Group Limited (ASX: REA), Altium Limited (ASX: ALU) and Ramsay Health Care Limited (ASX: RHC).  

If you hold a growing investment long enough you can eventually see that share pay large dividends compared to the initial investment price.

It’s possible to receive dividends from a wide array of businesses from a single investment when you buy an index investment through an exchange-traded fund (ETF) on the ASX such as iShares S&P 500 ETF (ASX: IVV), BetaShares Australia 200 ETF (ASX: A200) and Vanguard MSCI Index International Shares ETF (ASX: VGS).

One bonus with dividends from Aussie companies is franking credits. When a large company makes $100 of profit it’s taxed 30% of that profit, leaving $70 left for the company to pay a dividend or re-invest some. If the company pays the $70 as a dividend, the $30 company tax is “attached” as a franking credit which is either refunded in the tax return for low income earners (so the investor receives up to $100 as a dividend including the tax refund), or it reduces the tax liability for high income earners.

In my next article the next topic about why shares are so great will be about exchange-traded funds (ETFs), which are very effective investments for most people.

Foolish takeaway

Dividends are a great way to receive passive income from your investments as they grow profit and, hopefully, the share price over the long-term. I think the best dividend shares are ones that have yields between 3% to 6% or so, which is a good starting yield and leaves some profit for re-investment and future growth.

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Motley Fool contributor Tristan Harrison owns shares of Altium and RURALFUNDS STAPLED. The Motley Fool Australia owns shares of and has recommended RURALFUNDS STAPLED and Transurban Group. The Motley Fool Australia owns shares of Altium and Wesfarmers Limited. The Motley Fool Australia has recommended Brickworks, Ramsay Health Care Limited, REA Group Limited, and Vanguard MSCI Index International Shares ETF. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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