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The main reason we buy shares of a company is to enjoy a portion of the profits the organisation generates, and dividends are a major component of this - especially in Australia, where dividend payouts are typically much higher than in other markets such as the United States. In this article, we deep dive into what you need to know about dividends to make informed investing decisions.

Key takeaways

• Dividends are a form of investment return paid directly to shareholders out of company profits.
• A company’s board of directors can choose to pay a dividend on a regular schedule or any time it chooses.
• Dividends differ from capital gains, the other key form of investment return - this occurs when shares increase in value.
• Australia’s taxation rules are dividend-friendly and result in higher dividend payouts than in other markets.
• Investors can cash out or reinvest their dividends.
• Dividend reinvestment can be automated by using a dividend reinvestment plan (if available) or an online broker with Autoinvest

What is a dividend?

A company relies on investments from its shareholders to achieve its goals and grow its business to a point of profitability. In exchange for taking on this risk, investors expect to be rewarded for their investment if the company becomes successful.

Of course, investors can profit by selling shares as they increase in value, otherwise known as capital gains. But many firms further incentivise shareholders to keep their money in the company by compensating them directly. These payments are called dividends.

How dividends work

Dividends are an important aspect of owning shares and many investors expect regular payments as compensation for keeping their investment in the company.

When a firm decides to begin paying dividends, it will need to determine its payment schedule and the amount it will pay per share. For instance, let's say a company announces it will pay quarterly dividends of $0.50 per share. An investor who owns 1,000 shares will benefit not only from any increases in share value, but also from quarterly dividends of $500. That shareholder can then decide whether to cash those dividends out or reinvest them by purchasing additional shares.

A key decision companies need to make is how much of their money to keep in retained earnings and how much to return to shareholders. Retained earnings are important for keeping capital in a company and reinvesting profit in its future growth. This decision is ultimately made by a company’s board of directors.

Dividend Ex-Date vs Dividend Payable Date

When a company's board of directors declares a dividend, it will also declare an ex-date and a payable date. The ex-date is the date that the books of the corporation will be examined, and anyone who owns shares on that day will receive the dividend based on their total holdings. If you buy shares the day after the ex-date, you won't get the upcoming dividend payment; you'll have to wait for any future ones. The payable date is the date on which the dividend is actually sent to the owners.

Why some investors focus on dividends

When deciding which shares or exchange-traded funds (ETFs) to include in your investment portfolio, focusing on dividends is advantageous when it comes to maximising your returns. Research has consistently proven that the so-called "quality of earnings" for dividend-paying firms is higher than those that don't pay dividends. Over time, this means that dividend-paying firms tend to outperform non-dividend-paying firms.

Dividend-paying companies also typically endeavour to consistently maintain and increase their dividends, even during times of economic collapse. This means that returns from dividends are typically far more stable and reliable than capital gains. Additionally, the dividend typically provides share price support during periods of economic stress which keeps it from falling as far as companies who don’t pay dividends.

Exchange-traded funds (ETFs) and dividends

Exchange-traded funds (ETFs) are particularly well-suited for investors who like a significant proportion of their investment return to be dividends. This is because ETFs are a collection of shares, meaning that the investor receives dividends from many companies by investing in an ETF. This can result in a passive income stream that is more diversified and resilient than investing in a handful of companies, if you choose an appropriate ETF.

Thankfully, in Australia, choosing an appropriate ETF is easy - any low-cost ETF that focuses on broad market Australian indices will have a dividend yield of more than 3%.

Why some companies don't pay dividends

During periods of rapid growth, many firms do not pay a dividend, opting instead to retain earnings and use them for expansion. Owners allow the board of directors to enact this policy because they believe the opportunities available to the company will result in much bigger dividend payouts down the road, or the ability to sell shares at a much higher price (resulting in a larger capital gain).

When a company that doesn't pay dividends increases its shareholder equity, it is because investors anticipate that at some point they will receive their money back—either by increases in shareholder value or future dividends. This makes the company attractive to investors, allowing it to raise additional funding in the future.

Dividends vs capital gains summarised

Dividends and capital gains are the two most important forms of investor returns. The table below summarises the key distinctions between them.

It’s important to note that all shares offer the potential of capital gains, while not all shares offer the potential of dividends - regardless of how mature a company becomes. Amazon, for example, has never paid a dividend.

This is particularly true in overseas markets where tax treatment of dividends isn’t as favourable as it is in Australia.

Dividends in Australia

In Australia, franking credits are used to eliminate double taxation on dividends for local investors in local companies by allowing companies to pass on a tax credit equal to the amount of tax the company has already paid on the dividend.

A franking credit is a tax credit paid by companies to their shareholders at the same time as dividends are paid. Since corporations have already paid taxes on the dividends they distribute to their shareholders, the franking credit allows them to allocate a tax credit to their shareholders. Depending on their tax situation, shareholders might then get a reduction in their income taxes or a tax refund.

While franking credits make a lot of sense ("why tax investors twice on dividend earnings?!"), Australia (and the handful of other countries who allow franking credits) are the exception rather than the norm. Due to this, the average dividend yield of Australian companies is much higher than most other markets - such as the US.

Reinvesting dividends

When you reinvest your dividends, you take the money the company sends you and use it to buy more shares. You can have your online share brokerage firm do this for you (by paying dividends to your brokerage account and using a feature like Autoinvest), or you can sign up for a dividend reinvestment program (DRP).

A DRP is a company-sponsored plan that allows you to buy shares of stock directly from the company. DRPs often provide heavily discounted (and in a few cases, free) trading and administrative costs, and shares acquired via these programs are also sometimes issued at a discounted price.

Should you reinvest dividends?

The main financial perk of reinvesting dividends is that it maximises compound interest, enabling you to accumulate wealth faster than you otherwise would because you minimise the amount of time between receiving dividends and re-investing them, while also minimising the cost incurred when reinvesting.

The main psychological perk of reinvested dividends is that it’s automated, and so you don’t need to think about it. This technique is known as dollar-cost averaging, and it also has material financial benefits too.

Of course, the downside of choosing to reinvest dividends is that you don’t get to use them to pay bills, buy holidays, or invest elsewhere, so depending on your financial circumstances this strategy may not be suitable for you.

Ultimately, this is a decision you have to make for yourself! Whichever you choose, see below for how to make the most of each option.

How to automatically reinvest using a Dividend Reinvestment Plan (DRP)

To set up a DRP, you will need to create an account on the share registry of each of your investments. Once you have done that, you will be able to select “Reinvestment Plans” and opt-in for each share that you wish to reinvest dividends for.

Not all companies and funds offer DRPs, though. In these situations, the below strategy can serve you well.

How to automatically reinvest using an online share broker

To reinvest automatically using your online broker, you first need to ensure you have a broker that has an Autoinvest feature (hot tip: Pearler does!).

If you’ve got that sorted, then you need to create an account on the share registry of each of your investments. Once you have done that, you will be able to select “Payment Instructions” and assign the bank account that you hold with your online broker as the destination account for your dividend payments.

Next, log into your online brokerage account and set up your Autoinvest instructions!

How to cash out dividends into a bank account

To access your dividends you need to create an account on the share registry of each of your investments.

Once you have done that, you will be able to select “Payment Instructions” and assign your preferred bank account as the destination account for your dividend payments.