Dividends allow you to enjoy your share of a company’s earnings. Here’s how dividends work and how you can use them to boost your finances.
As a shareholder, you own a small part of a company. When that company makes a profit, a portion of those earnings are passed on to its shareholders in the form of dividends. This is your reward for investing in that company and is one way people can generate an income from shares.
What are dividends?
Every shareholder is entitled to their share of a company’s earnings and dividends are one of the ways companies reward shareholders for their investment. Usually paid twice a year, dividends are offered to shareholders on a per-share basis. The frequency with which a company pays dividends and the size of those payments is one of the factors many investors consider when buying shares.
It’s worth pointing out, however, that not all companies pay dividends - they are not required to pay dividends to shareholders and may instead decide to reinvest any earnings back into the company. There’s also no requirement for companies to pay dividends twice a year, so a company may pay more or less frequently than this.
Telstra pays out dividends
Justin has just received 15.5 cents in dividends per share he holds with Telstra. He’s already established with Telstra that he wants to reinvest all the dividends he gets paid back into Telstra, so he gains another 2 shares with the corporation.
How do dividends work?
The size of the dividend you will receive is determined by the company’s performance. Dividends are usually calculated as a percentage of a company’s earnings, and the amount you receive is often referred to as the dividend payout ratio.
As mentioned, the amount of the dividend payment you receive will be calculated depending on the number of shares you own. For example, if you own 5,000 shares in Company XYZ, which is paying a dividend of five cents per share, you will receive a payment of $250.
A company’s board of directors will decide when to pay a dividend and how much to pay. While they are usually issued as cash payments, dividends can also be offered in other forms, for example shares in the company.
Dividends can only be paid from a company’s profits for the current year or profits it has retained from previous financial years.
Back to topWhat are the types of dividend?
- Interim dividend. An interim dividend is a distribution of a company’s profits to its shareholders that is paid before the company has calculated its annual earnings. This dividend will often be released at the same time as the company’s interim financial statements, usually six months into the year.
- Final dividend. This dividend payment is released when a company announces its profits for the full financial year. For most Australian companies that offer dividends, the final dividend will be the second dividend payment for the year. However, some firms will only offer one dividend payment and others may offer more.
- Special dividend. Usually paid in cash, special dividends are typically noticeably larger than the normal dividends paid out by a company. A company may issue a special dividend to shareholders when it enjoys higher-than-normal profits across a certain period, allowing it to share its earnings with shareholders and also encourage loyalty.
How do I compare corporations that regularly pay out dividends?
If you’re considering buying shares in a company that pays dividends to shareholders, keep the following factors in mind:
- How often are they paid? Does the company pay dividends once a year, twice a year or more?
- How much are they? Take a look back at previous years to check the amount of the dividends offered by each company. What sort of income would they be able to generate for you? Have the dividend amounts grown over time in line with the company’s earnings?
- Dividend yield. The dividend yield is the amount of a dividend expressed as a percentage of the company’s share price. This is one figure that can be used to help determine the financial performance of a company and the return you are receiving on your investment.
- How long has the company been paying dividends? This can help give you an idea of a company’s reliability and financial stability.
- Is it franked or unfranked? If a company distributes its after-tax profits as dividends, those dividends are described a being franked. When you file your income tax return, you’ll receive a credit for the tax the company has already paid.
What are the pros and cons of investing with a company that regularly pays out dividends?
Pros
- Earn an income. You can use dividend payments as a form of income.
- Rewards. Dividends are your reward for using your money to invest in a company.
- Reliable. Several larger companies, for example banks, offer a steady and reliable stream of dividend payments to investors.
- Reinvest. Should you choose to reinvest you gain more shares of the corporation and also pump in extra capital.
Cons
- Tax. As dividends form part of your income, you’ll need to pay tax on any dividend payments you receive.
Are there any risks?
One issue to be wary of is investing in a company based solely on its history of dividend payments. Just because a company has a high dividend yield doesn’t mean it is a safe and stable investment, so do plenty of research before handing over your money.
Some companies will also offer dividends in the form of shares, which can sometimes seem like an unattractive option for investors looking for an instant cash return. However, these dividend reinvestment programs can be a great way for you to invest further and gain a bigger share of a company, so consider the merits of reinvesting before making a decision.
