What is a dividend?
When a company is profitable and has positive earnings, it may choose to pay a dividend to its common shareholders. Dividends can be seen as a reward from the company to its shareholders for investing in their shares. A dividend is typically paid out as a percentage of a company’s earnings; however, the payments are not compulsory and will typically depend on the company’s free cash flows. Typically, more established, and value-oriented companies will pay a higher dividend than newer, growth-oriented companies. Sectors that tend to have a higher dividend yield (as a consequence of being more profitable and have a history of rewarding shareholders) are:
- Health Care
- Consumer Staples
In contrast, sectors such as technology tend to have a lower dividend yield as companies typically reinvest their free cash flow and earnings into new growth projects.
Regular vs special dividends
Regular dividends are usually paid out consistently, with the company and its board of directors specifying a timeframe and payout rates. In Australia, regular dividends are typically paid out semi-annually whereas US-listed companies will typically pay quarterly dividends. There are also other investment instruments such as REITs (Real estate investment trusts), which can pay monthly dividends to shareholders. Management will typically attempt to keep dividends stable, as this allows shareholders to be more trusting of the company, and typically indicate the company’s performance is matching management’s expectations.
A special dividend is a non-recurring dividend that can be paid out to shareholders because of a special event. For example, if a company can successfully divest an area of the business and has no use for additional capital, management may choose to return this capital to shareholders in the form of a special one-time dividend payment. Special dividends can also be paid out if a company generates an elevated level of profits that are not expected to be sustained. For example, a mining company that generates excessive profits due to higher commodity prices may choose to pay shareholders a special dividend, however, this will likely only persist for as long as commodity prices are favourable.
Dividend vs dividend yield
When talking about dividends, we can typically refer to either one of two things:
- Dividend amount
- Dividend yield
The dividend amount is declared by the company and expressed as a dollar amount (e.g., an interim dividend of AU$1.00), whereas the dividend yield expresses the dividend amount as a percentage of the share price. More simply referred to as “yield”, the dividend yield can provide investors with an idea of how much cash dividend they can get as a proportion of their overall stock holding.
Why pay a dividend?
A company typically chooses to pay out dividends if the excess profits from operation have nowhere else to go. After covering the cost of operations and any interest payments, management will typically decide what to do with the remaining capital. Companies that are earlier stage or operate in a more competitive sector may choose to reinvest the additional capital into other areas of the business. For example, a communications company may choose to reinvest additional capital to develop 5G infrastructure, or a mining company may choose to purchase additional mines and/or mining equipment. However, if management decides there are no appropriate projects to undertake which will improve the company revenue growth, they will typically pay out the remaining profits to shareholders in the form of a dividend or share buybacks.
How are dividends paid out?
Cash vs stock dividends
The most common type of dividend payout is a cash dividend, where a cash amount is typically paid from the company, through a share registry, to shareholders’ nominated bank accounts. Shareholders can also choose to receive dividends in the form of a cheque mailed to their nominated address, however, most shareholders in Australia elect to be paid electronically. The alternative to paying a cash dividend is a stock dividend where a company pays out the equivalent amount in the form of shares of stock. In Australia, this is commonly known as a dividend reinvestment plan (DRP), where cash dividends are used to repurchase shares of the company. We cover more on DRP later in this blog.
Dividends vs buybacks
Dividends are commonly compared to share buybacks which is another common method of returning additional capital to shareholders. Buybacks involve the company using their additional capital to purchase their stock on the open markets. This can reward shareholders in two ways:
- EPS growth – as the number of shares decreases with increasing buybacks, the earnings per share will typically grow at the same rate
- Increase in share price – With share buybacks, the shares outstanding will decrease and the demand for shares will increase. This will typically drive the share price up allowing shareholders to benefit from unrealised capital gains.
The benefit of share buybacks is that shareholders do not need to pay any taxes on capital gains until they sell their shares, whilst shareholders need to pay taxes on dividends. However, in Australia, there is an imputation tax credit system whereby shareholders who receive a dividend will also receive franking credits as a tax offset. This makes dividends the preferred method of rewarding shareholders for Australian companies. However, companies based overseas where there is no imputation tax credits prefer to reward shareholders through share buybacks, hence they are very prevalent in the US.
A franking credit is a tax credit paid by corporations to their shareholders alongside a dividend payment. This eliminates double taxation on the corporate level (through corporate taxes) and then again on the personal level (through personal income taxes). Franking credits are provided to investors in a 0-30% tax bracket and paid out proportionally to the investor’s personal tax rate. Investors at the 0% tax rate will receive the full tax payment paid by the company in the form of a tax credit, whereas investors at a tax rate above 30% do not receive franking credits. Franking credits are very prevalent and found alongside many dividend-paying companies in Australia.
Dividend payout ratio
A dividend payout ratio is calculated by dividing dividends per share by earnings per share. This metric measures what proportion of the company’s earnings is paid out as a dividend. Typically, more established industries such as mining and tobacco will have a higher payout ratio. The payout ratio can be used to determine whether the dividend is sustainable, with any payout ratios above 100% being unsustainable as the company must borrow funds to keep up its dividend payment. For a financially strong company in an established industry, a payout ratio of under 75% is good whilst a payout ratio under 50% is considered good for less established industries. A lower payout ratio can indicate to investors that the company has sufficient retained earnings to take advantage of future growth opportunities.
Key dividend dates to be aware of:
The declaration date is the date on which the board announces and approves the payment of a dividend to shareholders. On this day, the company will announce the size of the dividend, how frequently will it be paid, when is the dividend payable, and the ex-dividend date.
The ex-dividend date refers to the day on which shareholders are eligible to receive a dividend. If you buy shares on the ex-dividend day (or after), you will NOT receive the dividend. On the other hand, if you owned the shares but decided to sell the shares on the ex-dividend date, you will still be paid the declared dividend. The ex-dividend is typically set one or two days before the record date and is determined by the exchange.
The record date is the day where shareholders must be on the company’s books in order to receive a dividend. The record date is set by the company, whereas the ex-dividend date is set by the stock exchange and there is typically a lag of two days between these two dates as financial settlement takes T+2 days. This means if someone buys the shares, it will take two days for this trade to settle and for the shareholder to appear on the company’s books.
This is the day where the dividend is paid to shareholders. Electronically transferred funds should be received by shareholders on this day.
DRP – You’ve heard it, seen it, read it, but what is it?
A DRP (dividend reinvestment plan) allows investors to reinvest their cash dividends as the company’s stock. Since the dividend is first paid out as a cash dividend, the investor will need to pay personal taxes on the dividend received. The benefit of DRP is that it allows investors to compound their dividends and get a higher rate of return over the long run due to the compounding effect. Investors can set up a DRP through their share registry, and once set up, dividends paid out in the future will automatically be transferred to shares and reinvested on behalf of the shareholder.
Trying to reap the benefits of a dividend with minimal exposure? Here’s how:
To be paid the next dividend, shareholders must own the stock on the record date. Since financial products take T+2 days to settle, this means an investor would have to purchase the stock on the market two trading days before the record date to receive the next dividend. This should also correspond to the trading day before the ex-dividend date.