What are dividends?

An introduction to dividends

Companies pay dividends to shareholders from the profit they make. It's essentially a way of rewarding them for investing in the business. 

As companies typically pass on a dividend payment to shareholders in cash, a dividend can be described as a 'cash dividend'.

Key takeaways:

• Cash dividends are common, but companies can also pay profits to shareholders in additional shares instead
• The dividend amount an investor receives depends on the number of shares they own
• Dividends often come with franking credits that can lower your income tax liability.

So, how do dividends work? 

Under Australian law, a company's board of directors can authorise a dividend if they are satisfied that the company:

• Has sufficient net assets
• Can still pay creditors after the dividend payment
• Is paying a dividend that is fair and reasonable.

The board must then decide how much to pay and when to distribute the dividend to shareholders. 

Not all investors consider paying out dividends the best move. Some believe reinvesting profits instead can increase a company's long-term value and deliver more significant shareholder benefits through a higher share price. 

However, others favour dividends because they want certainty and prefer receiving some income returns sooner rather than later. There can also be tax benefits for shareholders where a franking credit accompanies a dividend. 

A franking credit is a tax credit that can reduce a person's assessable income and lower their tax bill.  

You'll often come across the term dividend yield. It's a helpful metric for quickly identifying stocks that pay higher dividends. We calculate yield by dividing a company's annual dividend by its share price. 

An investor seeking dividends will also look at the dividend payout ratio and dividend history of potential stock investments.

Which companies pay dividends?

Mature companies typically have stable sources of finance, lower debt levels, and consistent profits, so they can afford to pay dividends. 

In Australia, large blue-chip companies from well-established industries such as banking and financial services, resources, and retail tend to offer higher dividends to their shareholders. 

Growth companies are likely to have higher investment expenditures and fewer sources of finance, so they tend to reinvest profits back into the business rather than distribute them as dividends.

Why do companies pay dividends?

Companies are not obliged to pay dividends. However, shareholders expect a return on their investment, and companies can deliver this through either capital gains or dividends. 

Since companies typically need to be profitable to pay dividends, their payment can signify financial strength and stability. It can attract new investors and lift demand for a company's shares. 

Hence, companies with a strong dividend history are often reluctant to reduce or stop paying dividends, as this can spook investors by giving the impression of financial trouble.

Of course, how companies pay dividends is just as important as why they pay. 

While cash dividends are more common, companies sometimes pay share dividends instead. Eligible shareholders usually receive cash dividends by direct credit. Share dividends are paid by allocating additional shares to eligible shareholders. 

There are no rules regarding how often companies should pay dividends, but many ASX companies pay an interim dividend and a final dividend each year. Sometimes, a company with exceptionally robust earnings will also pay a special dividend. 

Important dividend dates

You'll need to pay attention to the following dates to ensure you qualify for dividend payment:

Declaration date: This is when a company announces a dividend to the market. The announcement will include information such as the amount the company will pay in dividends and whether it will be a cash or share dividend. It will also declare the ex-dividend date.

Ex-dividend date: From the ex-dividend date onward, a share begins trading without the value of its next dividend payment. You won't get the upcoming dividend if you buy a stock on or after this date. The ex-dividend date is usually one business day before the record date. 

Record date: This is the date set by the company upon which you must be on the books as a shareholder to receive the dividend. At 5pm on the record date, the company will close its share register to identify the shareholders eligible for the dividend payment. 

Typically, the record date is set one business day after the ex-dividend date. Because share trades take two business days to settle, you must own the stock before the ex-dividend date to be a shareholder on record on the record date.

Payment date: This is when the company pays its dividend to shareholders.

How do dividend payments affect share prices?

A company's share price might rise in the period leading up to the ex-dividend date due to higher demand from investors buying shares to qualify for the dividend. 

The company's share price will likely fall by the dividend amount on the ex-dividend date. This is because investors who buy shares are now ineligible for the dividend from this point onwards. 

Are dividends relevant?

Some analysts consider dividends irrelevant. They argue that shareholders will still benefit if profits are reinvested in the company instead of paid out to investors because the share price will rise. 

However, given that dividends and capital gains are treated differently for tax, different shareholders may prefer one type of return over the other.

Buying dividend-paying investments

Dividend investing is highly popular with Australian shareholders, with many investors relying on the cash flow from dividends to fund their lifestyle.

Investors in dividend-paying shares can benefit from both capital appreciation and income payments. Investing in shares comes with volatility, but receiving regular dividends can reduce the perceived volatility by providing an income stream and return on investment independent of share price movements.

Most dividend-paying stocks give you a choice of how to use your dividends. You can take the cash and apply any applicable franking credits towards lowering your tax bill. Alternatively, if the company offers a dividend reinvestment plan (DRP), you can reinvest your dividends in more shares. 

Investors are usually offered a discounted share price for reinvestment through a dividend reinvestment plan (DRP). Opting into a DRP allows you to grow your portfolio without thinking about it. 

If you elect to participate in a DRP, you will still need to declare your dividend income as though you received it in cash on your tax return, but you will also get the benefit of applicable franking credits.  

Most ASX-listed companies pay dividends in Australian dollars, although companies that make significant income offshore may pay in another currency, such as United States dollars. 

While investors often focus more on payments made directly to shareholders by listed companies, mutual funds and exchange-traded funds (ETFs) also pass on dividend payments in the form of distributions. 

These come from the dividends that funds receive from dividend-paying shares in their investment portfolios. Funds typically pay shareholders monthly or quarterly distributions rather than twice a year.

• With additional reporting by Motley Fool contributor Kate O'Brien