Dividends are one of the great benefits of holding shares. They represent the distribution of company profits to the owners of a company – its shareholders.
Dividends provide shareholders with a passive income stream that can be used to fund a lifestyle, or be reinvested. They often come with tax benefits too – franked dividends include imputation credits, which can be used to offset tax payable by the investor.
Why invest for dividends?
Dividends come in the form of cash, so provide a periodic realised return on your investment. Capital gains are the other form of return on shares. To realise capital gains, however, shares must be sold. Potential capital gains can also disappear where the share price falls.
Reinvesting dividends is a quick and easy way to grow your portfolio. Many companies and exchange-traded funds (ETFs) offer dividend reinvestment programs that will automatically reinvest distributions back in that company or ETF. Investors can also direct dividends be paid into a separate bank account, and save them to fund new investment opportunities.
There can be tax advantages associated with receiving dividends. Franked dividends come with tax credits attached which means investors receive a rebate for tax already paid by the relevant company. If an investor's personal tax rate is lower than the company tax rate, they can receive a refund.
How to find dividends
Company profits can either be paid out as dividends or reinvested in the company to fuel future growth. Generally, mature, lower growth companies are in a better position to pay out a higher proportion of profits as dividends than smaller, higher growth companies. Companies in stable industries with predictable cash flows are more likely to be able to pay reliable dividends. Companies in emerging or cyclical industries are less likely to be able to sustain a high level of dividends.
Dividend yields and payout ratios
A company's dividend yield is its annual dividend divided by the share price. It represents the dividend-only return on the investment in the share. When dividends remain the same, the dividend yield on a share will rise when the share price falls and fall when the share price rises. Investors must be wary when using the dividend yield to guide investment decisions – it may be inflated due to a falling share price, and dividend cuts can and do occur.
A company's payout ratio shows the percentage of earnings that are paid out to shareholders as dividends. It is calculated by dividing the total dividends paid over a period by the company's earnings over that period. The payout ratio can indicate how sustainable a company's dividend payments are. A low payout ratio indicates a company is reinvesting most of its earnings into its business to spur future growth. A high payout ratio indicates that the opposite is true.
Different industries tend to have different payout ratios. Defensive industries with stable income flows such as telecommunications and utilities tend to have higher payout ratios. For example, AGL Energy Limited (ASX: AGL) has a target payout ratio of 75%. Industries with fluctuating cash flows or in cyclical sectors such as resources tend to have lower payout ratios.
Traditional dividend shares no longer so reliable
Banks, utilities providers, and real estate investment trusts have all historically been known for dependable dividend income. But the banks have taken a knife to dividends as profits plunge in the wake of COVID-19.
Commonwealth Bank of Australia (ASX: CBA) cut FY20 dividends by 32% as FY20 profits fell 11.3% to $7,296 million. Westpac Banking Corp (ASX: WBC) scrapped its interim dividend entirely last week and Australia and New Zealand Banking Group (ASX: ANZ) cut its interim dividend to 25 cents a share from 80 cents a share in 2019.
Utilities providers have been more reliable sources of dividend income this reporting season.
AGL Energy has a dividend yield of 6.31% and paid dividends of 98 cents per share in FY20, 80% franked. AGL targets a payout ratio of approximately 75% of underlying profit after tax where a minimum franking level of 80% can be maintained.
Telstra Corporation Ltd (ASX: TLS), with its high proportion of mum-and-dad investors, maintained its full year dividend of 16 cents a share, despite its net profit after tax decreasing by 14.4% to $1.8 billion.
Mining shares have also been known to pay substantial dividends when conditions allow. Rio Tinto Ltd (ASX: RIO) paid $3.6 billion in dividends in 1H20. Other than 2016, Rio has increased its dividend every year since 2010 and currently has a dividend yield of 5.62%.
BHP Group Ltd (ASX: BHP) paid dividends of 55 US cents per share in FY20, giving a payout ration of 72%. Both the big miners have benefitted from the increases in the iron ore price, which has been on the rise since March.
Dividend scans
A quick Google search will reveal the ASX shares with the highest dividend yields. Currently, these include Whitehaven Coal Ltd (ASX: WHC), which has a dividend yield of 11.65% and Yancoal Australia Ltd (ASX: YAL) which is yielding 15.70%.
Whitehaven Coal paid dividends of 1.5 cents a share in 1H FY20 despite a 30% drop in revenue, with CEO Paul Flynn saying, "the payment of a modest dividend reflects our confidence in the fundamentals of the business and prospects for a stronger second half."
Yancoal Australia also saw a fall in revenues in 1H FY20, but profits increased thanks to non-operating items of $575 million. Nonetheless, challenging conditions in coal markets meant Yancoal declined to declare an interim dividend in order to preserve cash. This is a timely reminder that high dividend yields are no guarantee that dividends will actually be paid.
Foolish takeaway
Dividends represent a tangible return on share investments. Whether used to fund current lifestyle needs or fuel future portfolio growth, dividends serve a crucial purpose in portfolio construction. But identifying shares that will consistently pay decent dividends is easier said than done. This is why diversifying sources of dividend income is recommended.
