Dividend Investing
Can lead to tax efficient investing!

Dividend investing refers to investing in stock whose earnings are passed on to shareholders, as an interim payment after a half-year report, and as a final payment after the annual report.

Dividends can vary from a few cents to a several dollars depending on the size and profitability of the company. Records of payments need to be kept for tax reporting.

If the payments are reported as franked, it means that the company has already paid company tax on the earnings. For investors in Australia, this means that the government is not 'double dipping' by requiring the investor to pay the full rate of tax on the earnings passed on by the company.

The dividend yield is obtained by dividing the dividend by the share price and expressing it as a percentage. The yield may vary from one or two percent to nine or ten percent.

'Growth' companies generally have low yields and mature companies with low growth characteristics that generate large amounts of cash commonly have larger yields.

Stocks paying large dividends are commonly referred to as high dividend stocks or dividend-paying stocks. They are popular with people who are investing during retirement.

Retirees commonly look for high yield dividend investing as this can result in tax efficient investing if the payments are fully franked.

Keep in mind that dividends are not guaranteed and are dependent on how much cash the company is prepared to pay out each year. This is reported as the payout ratio that varies across companies from about 20 – 100%.

How does dividend investing affect my buying policy? - I tend to invest in a mix of companies to achieve an average dividend yield of 4 to 5%, mainly fully franked. That is, dividends for which the company has already paid the company tax.

This ensures that if the market becomes depressed, as in the case of a stock market crash, I am still receiving a reasonable return on capital until better times arise.

I use some income from dividends to pay for the interest on a margin loan. The remainder I allow to accumulate in the investment account as capital for future purchases.

Because all my dividend income is not consumed paying for debt, I remain positively geared. This means my dividend income exceeds my interest payments.

The earnings you receive as a shareholder consist of dividends and /or capital gain (increased share price). Of course, you have to sell the share to realise the capital gain whereas the dividends will arrive as long as you keep the stock.

A little appreciated fact is that unlike interest payments from a bank, company dividends usually grow over time.

Shares provide a double-whammy effect of growing dividends and growing share price – if all goes well.

History demonstrates that the most profitable stocks over the last 50 years all paid dividends.

Also, historical studies of the long-term returns on shares indicate that, for Australian, British and U.S. share markets, dividends account for some 50% of returns.

Hence you ingore dividend investing as a powerful generator of capital returns at your peril! Dividends are a vital part of the overall return from the stock market.

To hammer this into your cerebral cortex a little further, you should also note that dividends are two to three times less volatile than share prices.

However, it needs to be kept in mind that for companies exhibiting a high return on equity (ROE), a large proportion of profits are better re-invested in the company rather than being distributed to shareholders. This particularly applies if the dividends are not fully franked.

Companies with high return on equity are in a better position to utlilse profits to increase value if the re-invested profits can be compounded at a high rate over a number of years.

Conversely companies with low return on equity should be distributing most of their profits to shareholders as re-investing earnings will result in the erosion of value unless their return on equity can be raised.

Some other terms associated with dividend investing include cum-dividend, ex-dividend and record date. You will see or hear these terms when a company declares a dividend.

Cum-dividend means the shares carry the entitlement to the dividend and if purchased 'cum-dividend', the buyer will receive the dividend.

Ex-dividend means without the dividend. Therefore if you see a company’s share price quoted 'ex-dividend', the dividend is earmarked for the seller, not the buyer. The market price will reflect whether the shares are 'cum' or 'ex' the dividend entitlement.

Record date is the date used to determine the shareholders on the register who are entitled to receive the dividend and the number of shares on which it will be paid.

It is the date where all changes to registration or banking details must be made for them to apply to the relevant payment.

Dividends can represent up to 40% of the return on an income portfolio, especially in countries like Australia where dividend payments tend to be higher than elsewhere.

I am not at all concerned if a company with a high stable or increasing return on equity is re-investing most of its earnings in the company. I am likely to be on a winner!

So while dividend investing is a good strategy to produce a healthy cash flow, there are other reasons why I might choose stocks that are holding on to their earnings, rather than giving them to me.

Return from Dividend Investing to Financial Measures