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It’s time to tap into the amazing power of dividends

When it comes to investing, many investors focus solely on share price movement. But an increasing share price is not the only way to make money in equities.

Throughout the year, listed companies pay out a dividend to shareholders and Australian listed companies are some of the biggest dividend payers in the world.

What exactly is a dividend?

In a nutshell, dividends are a share of a company’s profits paid to the company’s shareholders. It’s basically a reward for investing in their business – or part-owning the company. If you invest in an ETF (exchange traded fund), the dividend is allocated to you as part of a distribution.

A company’s board of directors authorises a dividend to be paid, how much will be paid and whether the dividend will be paid as cash or as additional shares. Australian law specifies that they must be satisfied that the company:

  • Has sufficient net assets to cover the dividend.
  • Is paying a fair and reasonable dividend to all shareholders.
  • Can still pay all its creditors after the dividend payment.

Rather than pay a dividend, some boards will reinvest a company’s profits to increase the long-term value of the company. This in turn can deliver greater shareholder benefits through a higher future share price.

For many investors, though, payment of a dividend provides a more reliable return on their investment in the form of a consistent income stream. Dividends are tied to a company’s profitability, not its share price. Even in a rocky market, a company may still pay dividends.

Top dividend payers

So, dividends can make a stable contribution to an investment’s total return. In fact, shares with good dividends can reduce the year-to-year volatility of capital gains. This is especially true as it’s generally agreed that shares paying dividends tend to be more resilient and stable.

To identify top dividend-paying stocks, calculate the dividend yield – the annual dividend divided by the share price. This allows for comparison between stocks, however for long-term stability, remember to focus on consistent dividend growth over the long term. Mature sectors like banking, mining, energy and property are also a more stable bet for regular dividend returns.

These are also the sectors more likely to offer fully franked dividends, which offer impressive tax benefits to investors.

What are franking credits?

Franking credits are a tax rebate paid to investors with shares in Australian companies. They were set up in order to avoid double taxation as the company you invest in has already paid the ATO the tax on its profits. So when the company pays your franked dividend (or your share of its profits), you receive a tax ‘credit’ of the amount of tax it has already paid on that money.

At tax time, you declare the tax credits plus the dividend income you’ve received. The tax credit will count towards your overall tax bill (which includes tax owed on all your income streams, not just your dividends). If your top tax rate is less than the company’s tax rate, the ATO will refund you the difference.

This is one of the reasons why franked dividends are so good for retirees. Their taxable income in any given year is usually relatively low, so they often see franking credits paid back in full.

Note that not all dividends are franked. Unfranked or partly franked dividends are those that the company has distributed to shareholders without paying tax on them in full. The associated tax benefits of franking credits do not apply to unfranked dividends, so if the tax incentive is important to you, make sure you check what kind of dividends are issued before investing.

Compounding the returns

While the tax breaks and regular income are great, the true power of dividends comes from reinvesting. Some companies will automatically do this for you – paying out their regular dividends as shares in the company rather than cash. But even if you receive your dividends as cash, it’s worth electing to have your cash dividend buy more shares in the company. You can make this a ‘set and forget’ investment strategy, which requires no commissions or other brokerage fees to implement. Your dividends buy more shares, which increases your dividend payout, which buys you even more shares, and so on.

By reinvesting your dividend, you also get the benefit of dollar cost averaging (DCA). This is a strategy where over a long period of time you regularly buy shares in the same company, regardless of what the share price is doing. DCA is an effective way to slowly build long-term wealth while decreasing the risk attached to the share price on any given day.

The information provided in this article is of a general nature only and should not be considered as a recommendation or endorsement by PSPL of any product, service or advice contained in this publication. Please consider your personal circumstances and seek professional advice, if necessary.