What are dividends ? A comprehensive guide for investors

Investors often rely on dividend-paying stocks for stable income, especially for retirement or consistent earnings. However, is this approach optimal for growing wealth through stocks? Understanding dividends' significance and the rationale behind companies issuing them is crucial for fine-tuning your investment strategy in the stock market.

Understanding dividends:

There are two primary avenues for earning returns from owning shares in a company: firstly, through the appreciation of the company's value and its share price over time, and secondly, via dividends, which can serve as a source of passive income.

Deciphering dividends

Dividends represent a company's allocation of a portion of its earnings to reward and incentivize shareholders. If you possess shares in a dividend-paying company, you'll receive a share of the profits corresponding to your shareholding, either in cash or as additional shares. The decision to issue dividends, the amount distributed, and the frequency of payments are determined by each company.

How are dividends impacted by taxes?

Certainly, dividends are considered taxable income. Nonetheless, if you receive fully or partially franked dividends from a company, you might be eligible for tax credits. This indicates that the company has already paid some or all of the tax owed, which can be used to reduce your personal income tax liability.

What is the amount of compensation you receive?

Does the quantity of shares you possess influence your portion of the dividend? The dividend amount, expressed as a value per share (e.g., 30 cents per share), fluctuates considerably based on the company's performance and profitability.

While high yields are favorable, when yields surpass 10%, it could suggest that the stock is volatile and carries higher risk.

Understanding dividend yield

Dividend yield serves as a metric to gauge the potential return on investment in a stock. It's represented as a percentage and is calculated by dividing the annual dividends per share by the current share price. While higher yields are favorable, exceeding 10% may signal increased volatility and risk. For instance, if a company pays $2 in annual dividends per share and its share price is $20, the dividend yield would be 10%. However, if the share price drops by half, the yield doubles to 20%, suggesting potential issues with the company's sustainability in maintaining future dividends.

Investing with Dividends

To delve into dividend investing, begin by researching companies listed on the stock exchange that have a history of paying dividends. Utilize features on stock trading platforms or explore resources like investor relations information and annual reports available online for individual companies. The ASX provides a Dividend search tool that enables you to explore both past and current dividend announcements.

Comparing dividend stocks and dividend funds

To qualify for dividends, you can invest directly in individual stocks, opt for exchange-traded funds (ETFs), or select a managed fund focusing on assets with dividend potential.

Managed funds are professionally managed but may entail higher fees and impose conditions like minimum investment thresholds and withdrawal restrictions. Your investment is combined with that of other investors and managed by a professional fund manager who selects a diversified mix of assets, including dividend-paying stocks.

ETFs, another pooled investment option, provide diversification and are traded on the stock exchange. Depending on the ETF's composition, you may gain exposure to dividend-paying stocks.

For self-directed portfolios managed through trading platforms, purchasing individual dividend-paying stocks is feasible but may be costlier and more time-consuming than investing in diversified funds or ETFs.

What is the mechanism behind dividends?

When a company chooses to distribute dividends, several key steps are taken:

• Company leadership and the board decide on the amount of profit to distribute and approve the dividend.
• he company publicly announces its intention to pay dividends, specifying the value per share or alternative options like a dividend reinvestment plan (DRP).
• An ex-dividend date is established, indicating the deadline for purchasing shares to qualify for the dividend.
• A payment date is set by the company, typically occurring about a month after the ex-dividend date.

Understanding non-dividend paying companies

Companies in their early stages or experiencing rapid growth might prioritize reinvesting profits into expansion, product development, or research rather than distributing dividends. Conversely, established and highly profitable firms may opt not to pay dividends due to their distinct operational and financial strategies. For instance, tech behemoth Google, despite being immensely profitable, has never issued dividends to investors. Choosing to reinvest profits may be viewed as a more favorable approach to enhancing a company's stock value, signaling long-term sustainability. 

Reasons behind companies issuing dividends

Certain companies maintain a regular schedule of dividend payments recognizing that many investors prioritize earning income from their investments. This practice not only attracts new investors but also maintains the satisfaction of existing ones, which is beneficial for the company's growth. Additionally, offering dividends in the form of discounted shares incentivizes shareholders to further invest in the company. Dividend payments can also impact market sentiment, as a company must have stable earnings and a solid foundation to sustain regular payouts. By consistently paying dividends, companies portray themselves as financially robust, potentially leading to increased demand for their stock and subsequent price appreciation.

Assessing the effectiveness of dividend investing

Investing in shares is often considered a prudent long-term strategy. Therefore, purchasing stock in established, profitable companies capable of paying dividends can potentially enhance portfolio stability and provide income opportunities. Alternatively, investing in emerging, high-growth companies with lower dividend yields may offer value if their stock prices appreciate over time.

However, some investors opt for stocks without dividends due to several common reasons:

• They wish to avoid the complexities associated with dividend-related taxation.
• Their focus lies on long-term capital appreciation rather than generating income from their investments.
• They believe that increasing a company's share price is better achieved by reinvesting profits to enhance the company's overall value.

Understanding the pitfalls of dividends

The primary concern revolves around the absence of assured dividends, which can diminish or cease entirely should a company's circumstances or objectives evolve. Companies frequently adapt their dividend strategies to allocate profits differently or when faced with declining earnings.

This underscores the broader risks inherent in stock market investments—economic fluctuations, market volatility, and corporate setbacks. Developing a thorough comprehension of investment motives, seeking professional guidance, and diversifying one's portfolio can aid in risk management.