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What are dividends and how do they work?

Dividends allow investors to enjoy a share of a company's earnings. Here's how they work and how they can benefit you.

When you buy shares in a company, you're effectively buying a piece of that company, which means you're a part-owner. As a shareholder, you're entitled to the company's profits. In investing terms, these are known as dividends.

Learn about the different types of dividends, how they're applied and how they impact your taxable income in this guide.

What is a dividend?

A dividend is a share of a company's earnings given to shareholders as a cash payment into their bank account, usually twice a year.

The size of the dividend you receive is in proportion to the number of shares you own.

The more shares you own, the bigger your dividend payment will be.

For example, let's pretend a company that sells items for household pets called Pets Galore is offering a dividend payment of \$0.05 for each share held.

If you owned 1,000 shares, you'd receive a dividend of \$50. If you owned 10,000 shares, your dividend payment would be much larger at \$500.

What is the ex-dividend date?

To receive a company's dividend payment, you must hold the shares prior to its ex-dividend date. If you buy shares on or after an ex-dividend date, you will be eligible for the next dividend payment, if there is one.

What is the dividend yield?

The dividend yield is presented as a percentage and indicates the value of the dividend payment in relation to the cost of the shares. It is calculated by determining what percentage of the share price is returned to the investor as income.

The dividend yield helps investors compare similar companies. It gives you an idea of which one offers a better return on your money in the form of a dividend.

Dividend yield example

Let's look at Pets Galore again with its dividend payment of \$0.05 per share. If the current share price was \$2 per share, the dividend yield would be 2.5%. If the share price was instead \$0.50 per share, the dividend yield would be a lot better at 10%. Because the yield is calculated using the share price, the yield will change daily as the share price changes.

Types of dividends

There are 3 main types of dividends that are paid at different times:

• Interim dividend. This is a dividend paid before the company has calculated its annual earnings. It'll usually be paid at the same time as the company's interim financial statements, usually 6 months into the financial year.
• Final dividend. This dividend payment is paid when a company announces its profits for the full financial year. Some companies will only pay a final dividend.
• Special dividend. These are bonus dividends and are typically larger than the normal dividends paid out by a company. A company may issue a special dividend to shareholders when it achieves higher-than-normal profits across a certain period.

Why invest in dividend stocks?

Investors who buy dividend stocks usually do so because of the steady income stream that comes from them.
While nothing in investment is guaranteed and it all comes with risks, dividends are usually a sign of a company's well-being. As such, well-established businesses will often look to at the very least pay the same dividend as the previous corresponding period, even in tougher economic times. If they were to cut dividends, it's usually seen as a bad sign by the market, which can result in a lower share price.

Dividend yields reach \$97.7 billion

The latest figures released by Janus Henderson show that Australians received a record AUD\$97.7 billion over the last corresponding period. A strengthening Australian dollar played a large role in reaching this record.

Not all companies pay dividends

Instead of paying shareholders a dividend, a lot of smaller, newer companies will reinvest any profits made back into the company to help it grow. However, many investors are okay with this because if the company is growing, the value of their shares will grow too.

It's also important to note that dividends are never guaranteed. Each company decides what the value of the dividend will be and if there will even be a dividend payment at all, annually. So just because a company pays a large dividend one year doesn't mean it will do this again the following year.

How are dividends paid out?

Dividends follow a chronological order of events that shareholders should keep an eye out for.

1. The company's business operations make it some money.
2. The company lodges its finances and its board of directors chooses how much to pay out in the form of a dividend.
3. The announcement date occurs when shareholders can vote on whether or not they approve of the board's plan.
4. Shares go ex-dividend. When this date is declared, investors must hold the shares the day prior to get any of the dividends.
5. The company will then have a record date for the cut-off and a payment date for when shareholders will receive their dividends.

Paying taxes on dividends?

Because dividend payments are a form of income, you do need to include these in your total taxable income when you file your tax return.

However, thanks to the franking credits system in Australia, you often won't need to pay much tax on your dividends (or any at all).

Fully franked dividends mean the company has already paid tax on the money at the company tax rate of 30%. So the money isn't being taxed twice by the Australian Taxation Office (ATO), you'll receive a franking credit for the tax already paid on the dividend by the company.

This means that while you do need to include the dividend in your total taxable income, you'll receive a discount credit that will reduce your taxable income by the amount already paid by the company.

How does a dividend reinvestment plan work?

Some companies offer what is called a dividend reinvestment plan (DRP), which allows you to opt in to using your dividends to buy more shares in the company instead of receiving the dividend payment in your bank account.

There are several advantages of doing this, but the main one is you're able to use the money to buy more shares without paying any brokerage fees.

It's also a good, passive way to increase your position in a company gradually over time with little to no effort from you. It's a good set-and-forget investment strategy: once you opt in, it all happens in the background automatically.

One downside of opting in to a DRV is you're unable to use that cash for day-to-day purchases like you could if you had received it in your bank account. You also don't get to choose at what share price you'd like to buy more shares: the shares are automatically bought on your behalf on the date of the dividend payment.

How to compare dividend-paying shares

If you're comparing a bunch of dividend-paying companies, here are a few things to keep in mind.

• How often are dividends paid? Some companies pay dividends several times a year while others only pay once.
• Have dividends been confirmed? Companies will often confirm in advance their dividend payments for the year ahead.
• Are dividends growing in value? Take a look back at the dividends paid by each company over previous years. If the value of the dividend has gradually increased, this is a good sign the company is growing and will likely continue to increase its dividend.
• What's the dividend yield? Is the yield higher than what you could earn with a high interest savings account?
• Is it fully franked? If the dividends aren't fully franked, when you file your income tax return you won't receive a credit and you'll need to pay the full income tax on the dividend yourself.

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