What is a dividend?

Key highlights:

• A company's board of directors determines how much capital they require to facilitate optimal growth. Any leftover capital is often paid out to shareholders as a cash dividend.
• A regular cash dividend is quoted as a percentage (yield), relative to the share price.

One of the greatest perks of investing is the chance to become a part-owner in any listed company. This is more significant than it may appear on the surface. As an owner, you may also be entitled to a slice of profits in the form of dividends.

Key dividend terms

Before we dive into the topic of dividends, there are four key terms to remember:

What is a dividend?

Shareholders are owners of a company. It may seem obvious but the significance of such a position can be understated. As an owner you are entitled to company profits; a dividend.

In Australia, a dividend is a fixed portion of profits paid per share to shareholders. Stocks traded in the U.S. are not required to pay dividends from profits. Either way, the payment is quoted as a percentage (yield), relative to the share price.

Let’s use the fictitious company Stakest (ASX: STK) through our examples. A growing and profitable company producing cutting-edge technology to solve the world’s biggest existential problems.

Stakest is trading at $100 a share with dividends paid over the last 12 months totalling $1 per share. Therefore, the dividend yield is 1%. Note that the most recent full-year dividend is used in the yield calculation. It’s a backward, not forward, looking metric. Companies constantly change their dividend based on their profitability and capital expenditure. It’s best to check a company’s dividend schedule which features its upcoming dividends.

What is a dividend payment schedule?

Dividend paying companies will frequently provide the shareholders with 12 month forecasts, in line with a stated retained earnings payout ratio range. Simply put, the company's board of directors looks at its capital commitments over the next few years, combined with its forecasted earnings growth, and decides what percent of the company's earnings it can likely afford to payout. This is also known as the dividend payout ratio.

How do dividends work?

Firstly, you must be holding the stock on the ex-dividend date. The ex-dividend date is usually two weeks before the dividend is paid. The ex-dividend date often sees increased trading as traders attempt to become eligible shareholders by buying the stock and selling once the dividend has been paid. You must have bought before, not on, the ex-dividend date. This date is set by the stock exchange.

Once the payment date arrives, you will receive your dividend paid in the currency in which the company's share price trades. Stake Wall St customers will receive their stock dividend in USD, while Stake AUS will receive it in AUD.

Stock dividends are usually paid quarterly. As such, you will receive a quarter of the forecasted annual dividend (assuming regular dividends). However, some dividend payouts occur monthly, it all depends on the board of directors.

Example of a dividend

If you own 100 shares of Stakest, and the company declares a regular dividend of $1 for the year, you are likely to receive $25 in dividend payouts each quarter.

Types of dividends

The most common form of a dividend is a cash payment. The dividend will appear as cash to be withdrawn, reinvested or held in your Stake account.

Still, dividends aren’t always paid in cash; some are paid in scrip. A scrip payment involves the issuance to shareholders of new shares in what is known as a scrip dividend.

A scrip dividend is often used by companies looking to preserve cash but still share profits with shareholders. For example, if a company needs to preserve cash for an expansion, shareholders are more likely to be satisfied if the dividend is replaced with scrip. Still, scrip dividends are far more common in the U.S. and UK than in Australia.

Lastly, a Dividend Reinvestment Program (DRIP) allows investors to reinvest a cash payment directly into shares. While this plan is usually run through the individual company, it’s on Stake’s road map to launch DRIP investing!

Taxing dividends

Now that we know the three types of dividends let’s briefly explain how they are taxed.

Cash dividends are classified as income and are taxed under your income tax rate. Since you receive the cash first with a Dividend Reinvestment Program (DRIP), they are also taxed as income.

A benefit of scrip shares is they are taxed as capital gains, not income. While scrip dividends are not eligible for franking credits (more on that soon), you can delay the tax hit until the shares are sold.

One of the unique benefits of investing in Australian stocks is the system of franking credits. Franking credits are an income tax deduction that refunds the portion of the dividend where the company has paid tax.

So, how do you know if you are entitled to a franking credit deduction? When a company issues a cash dividend, the dividend is either fully, partially, or not franked, depending on the percentage of the company’s profits that paid tax in Australia. This percentage forms the deduction you are entitled to on your income tax.

For example, the Woolworths Group’s (ASX: WOW) dividend is fully franked. This means that Australia has already taxed 100% of the profit used to pay the dividend. Therefore, you will receive a tax deduction on top of the dividend based on the company’s corporate tax rate. So when looking at a company’s dividend yield on the ASX, be sure to look at its percent franked, as a company with a fully franked dividend might offer more than first meets the eye.

Why do companies pay dividends?

Now you’re probably asking, why would a company want to forego their profits and hand back cash to thousands of investors. Companies mostly pay dividends to shareholders to reward the risk they take in investing in their stock.

At times, companies still make dividend payments even when they don’t see growth in their profits. They may do so to maintain their established track record of making regular dividend payments. Another common use of dividends is by companies in contracting industries like newspapers and coal. In these industries, management has largely stopped making long-term investments, and are instead funnelling the cash directly to shareholders. Still, companies must pay dividends directly from profits in Australia, although this is not a requirement in other countries like the U.S.

What types of companies pay dividends?

Companies of all shapes and sizes pay dividends, but certain types and industries are more likely to provide dividend income.

Three of the most common industries to offer an annual dividend are financial institutions like banks, real estate investment trusts (REITs) and established metals and mining stocks.

An industry famous for retaining its capital in exchange for growth is tech stocks like Facebook (NASDAQ: META), Amazon (NASDAQ: AMZN), Netflix (NASDAQ: NFLX), and Alphabet (NASDAQ: GOOGL) - AKA FANG.

Over on Wall St, U.S. companies were able to increase dividend payouts by 2.6% in total in 2020. But the Dividend Aristocrats are a group of stocks that have increased their dividend payout for 25 consecutive years. Many fit the definition of a blue-chip, bottom drawer stock. Names like AT&T (NYSE: T) and Bank of America (NYSE: BAC) are textbook examples. McDonald’s (NYSE: MCD), 3M (NYSE: MMM), Johnson & Johnson (NYSE: JNJ), and Coca-Cola (NYSE: KO) also hold a place in the upper class of dividend stocks.

As with most things, there’s an ETF for it! If your investment strategy focuses on established companies with a strong dividend growth track record check out the S&P 500 Dividend Aristocrats Proshares (NOBL), a U.S. ETF tracking the dividend aristocrats. But remember, past performance is not indicative of future results.

How to evaluate dividends?

Don't be fooled by high-yielding stocks. Dividend-paying companies with an unusually high yield may look appealing, but remember that yield is a function of a stock price. It is possible that a high yield is matched by a decreasing stock price. Similarly, a decreasing yield may be unappealing but if matched by an increasing stock price it becomes a desirable problem to have!

We mentioned before a key difference between dividend-paying stocks listed in Australia versus Wall St. In Australia, only profitable companies can pay dividends from profits, while in the U.S., no such restriction exists. Therefore on Wall St, a company can issue new stock to pay for its operating expenses while increasing its dividend. If there is anything the recent volatility of the last two decades has proven, even an investment strategy focused on the dividend aristocrats can't ignore a company's fundamentals.

How do dividends affect a stock's share price?

Regular dividends are announced to the market well in advance, usually allowing investors to buy the stock before the ex-dividend date. This makes sense from a fundamental point of view. If you would normally pay $1 for Stakest, but the company announces a cash dividend of $0.10, many investors would be willing to pay a premium of up to $0.10 per share. That is, until the company pays the dividend.

The removal of this temporary premium on the ex-dividend date theoretically increases the likelihood of the stock price dipping as investors exit having received their portion of the company earnings. While this phenomenon does occur in real life, remember that a stock's price is determined by many different data points and this is only one.

How often are dividends distributed to shareholders?

Dividends are primarily paid on a quarterly basis. But it isn't unheard of for dividend payments to occur on a semi-annual or even monthly basis.

If you have any questions about a company's individual dividend payments schedule, the information is usually listed clearly in its annual report or the investor section of its website.

The one exception to these rules are special dividends. These are paid out at the board of directors' discretion for a variety of reasons, including the sale of a division, unexpected and significant profit, etc.

Dividend FAQs

Why do companies pay dividends?

At a fundamental level, companies exist to grow shareholder value. However, there is a certain point for each company where shareholder value would be better served as cash in their hands. This is the main situation where paying dividends comes into play.

Another common example is if an industry is in a perpetual decline like newspapers or coal. These companies have higher than average dividend payout ratios as it encourages shareholder investment.

How to calculate dividend yield?

The dividend yield is calculated as the percentage of the current share price paid out over the last 12 months.