Dividends are paid to shareholders from the profit a company makes. It’s essentially a way of rewarding them for investing in the business.
As earnings are usually passed on to shareholders in the form of cash, dividends are often described as cash dividends.
- Cash dividends are common, but profits can also be paid in additional shares instead
- The dividend amount you receive depends on the number of shares you own
- Dividends often come with franking credits that can potentially lower your income tax liability
So, how do dividends 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 they prefer to receive some returns sooner in the form of income.
Another benefit of dividends is that they often come with franking credits. These are tax credits 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 quickly identify stocks that pay higher dividends, and is calculated by dividing a company’s annual dividend by its share price.
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 a dividend payment:
- Declaration date: This is when a company announces a dividend to the market, including how much it will be and whether it will be a cash or shares dividend. It will also declare the ex-dividend date
- Ex-dividend date: You need to own the company’s shares on this date in order to receive the dividend announced
- 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 date: This is when the dividend is paid to shareholders.
Impact of dividends on share price
Leading up to the ex-dividend date, a company’s share price might rise as a result of higher demand due to investors buying shares to qualify for the dividend.
On ex-dividend date, the share price of the company is likely to fall by the dividend amount. This is because investors who buy shares from this point onwards are ineligible for the dividend.
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 is a signal of financial strength and stability. This can attract new investors and lift demand for a company’s shares. Hence, dividend paying companies 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 are just as important as why they’re paid.
While cash dividends are more common, companies sometimes pay share dividends instead.
There are no rules regarding how often dividends should be paid, but many ASX companies pay an ‘interim’ and a ‘final’ dividend each year.
While dividend definitions often focus on payments made directly to shareholders, a mutual fund will also pass on dividends it receives from dividend paying stocks in its investment portfolio to fund investors. These dividends are called distributions.
Are dividends irrelevant?
Some analysts consider dividends irrelevant. They argue that shareholders will still benefit if profits are reinvested 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 stocks benefit from both capital appreciation and income payments. Shares investing comes with volatility, but regular dividends can reduce that somewhat. Most dividend paying stocks provide you with a choice as to how to use your dividends. You can choose to take the money, along with any franking credits that you can use to lower your tax bill.
Alternatively, you can reinvest your dividends in more shares automatically through a company’s Dividend Reinvestment Plan (DRP), if they have one. Investors are usually offered a discounted share price for reinvestment. This allows you to grow your portfolio without even 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.
For all of these reasons, dividend investing is highly popular in Australia.