Dividend Basics

We are at that time of the year when many companies on the ASX declare their interim dividends. Here is what you need to know about company dividends.

Why are shareholders paid dividends?

When a company makes a profit, they can reinvest the profits into the company or they can distribute these profits to the shareholders in the method of a dividend.

Usually, the companies who pay these dividends are mature companies and can afford to distribute the income to their shareholders. Small companies or companies in the growth phase are more likely to keep profits within the firm to use to expand operations further. Hence investors looking for income tend to invest in large cap stocks instead of small cap stocks.

When do you have to buy the stock to receive the dividend?

Shareholders need to buy the stock before the ex-dividend date. If the purchase is made on or after ex-date, the shareholder will not be eligible for the dividend. These dividends are paid on payment date which is about a month after ex-date. Shareholders can also elect to have the dividend paid as stock by selecting the dividend reinvestment plan, if the company offers this choice. Shareholders can sell the stock on or after ex-dividend date and still receive the dividend.

Dividend Yield

Shareholders can identify the companies which pay large dividends by looking at the dividend yield. Anything larger than 6% is considered a large dividend. To calculate the dividend the formula is =annual dividend per share/current share price.

Taxation

Companies which pay out dividend do so on profits which have already been taxed. To prevent double taxation, shareholders receive franking credits which is a tax offset for the tax the company has paid on the income.

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What is the difference between a dividend and a buy back?

Both of these involve paying profits back to the shareholder however a buy back means the company is buying back their shares which reduces the number of shares outstanding. This can be beneficial by increasing the company’s EPS (earnings per share) as the earnings is now divided by less shares which means the ratio is higher.

Dividend Stocks vs growth stocks

Firms which pay dividend are usually established big cap companies which could mean they have already passed their growth phase and may not have much capital gains potential as smaller caps. However, investors often end up sacrificing capital gains for income when investing in dividend stocks. Refer to our previous article “Investing for income? You are doing it all wrong” on why investing for dividends only can lead to poor results. Growth stocks can gradually increase their dividends and investors can benefit from a capital growth as well as dividend over time.

Lauren Hua is a private client adviser at Fairmont Equities.

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