Dividends are an important source of income for investors, particularly in Australia with the benefits of the federal government’s dividend imputation system.
But they don’t come without risk because they are not guaranteed and companies can reduce dividend payouts, as demonstrated during the COVID pandemic.
Dividends are payments to shareholders from a company’s after-tax earnings. They are a form of income from investing in ASX listed stocks. Not all companies pay a dividend, and it is not compulsory for profitable companies to pay dividends.
Having said that, Australian companies tend to pay out a high proportion of earnings as dividends, as measured by the dividend payout ratio. Listed companies have, on average, paid out 65% of their earnings in the form of dividends from 1917 to pre-COVID1.
Dividends declared at the half year accounts, normally February for companies with a June 30 balance date, are known as “interim” dividends. Those in the end of the year accounts are “final” dividends and are usually declared in August. Together, interim and final dividends make up the “full year” dividend of a stock.
Dividends are considered income for taxation purposes – you will need to include them in your annual tax return.
Australian investors have become accustomed to using shares as income-generating investments, making use of the attractive attributes of the dividend imputation system.
Because dividends are paid from after-tax income of a company, taxing shareholders on dividends would amount to double taxation. So, shareholders receive a rebate for the tax paid by the company on profits distributed as dividends.
These dividends are described as being 'franked', because they have a franking credit attached to them which represents the amount of tax the company has already paid. Franking credits are also known as imputation credits.
It’s important to remember that dividends come out of company earnings and are not certain in any financial year. If a company has a bad year, it can reduce its dividend. For example, during the COVID pandemic, companies cut or suspended their dividends without warning. Equally, not all stocks on the ASX are dividend paying, with management preferring to reinvest the retained earnings into growing the business instead of distributing it to shareholders.
Even the stocks most used for income investment, the big four banks and Telstra, have had occasion to cut their dividends.
A self-managed superannuation fund (SMSF) operating in accumulation phase, building a nest egg, pays a 15% tax rate on earnings. This applies to all income, not just to dividends but also includes interest, net capital gains, taxable managed fund distributions, as well as concessional contributions. The 15% tax rate on earnings is lower than the general 30% rate for companies, meaning the franking credits available can offset or reduce the tax payable within the SMSF. If the franking credits are greater than all of the tax payable by the SMSF it will receive a refund of this excess after it lodges its tax return.
An SMSF completely in retirement pension phase (paying regular income members after retirement) does not pay tax on earnings. As a result, it receives a full rebate of the value of the franking credits, because it has no tax to offset. The SMSF will receive a refund of the excess franking credits after it lodges its tax return.
For SMSFs, the dividend imputation system means that a dollar of fully franked income is effectively worth more than a dollar. SMSF investors have used these rebates to great effect to income.
Dividend yield refers to the dividend payout as a ratio to the share price. The yield of a dividend rises as the share price falls and falls as the share price rises.
Changes in share prices, and dividends, can have a positive or negative effect on the investor’s outcome depending on the circumstances.
When you buy a stock, the price you pay will determine the yield that the dividend represents to you. Regardless of the yield quoted on the stock in the newspaper or online, whether it uses historical (last year’s paid dividend) or projected (analysts’ consensus estimates) dividends, your eventual yield on a stock is determined by your buying price and the actual dividend you ultimately receive in the future.
Dividend yield examples:
Say a particular share is currently trading at $30 and offers a full year expected dividend of $1.90. This would equate to a yield of 6.3%. If the company exceeds its earnings expectations and ultimately decides to pay out a full year dividend of $2.30, the investor would realise a better-than-expected yield of 7.7%.
That is the positive impact of a growing dividend stream. But the same effect can work in reverse. Consider the example of Telstra. In May 2017, Telstra was trading at $4.40. On the expected 31 cent dividend, it was yielding 7%, fully franked.
In August 2017, Telstra announced that it would pay out between 70%–90% of earnings in dividends, rather than close to 100%. It was the first major change in dividend policy since the telco was floated by the government in 1997.
On that basis, Telstra's pay-out to shareholders could be expected to fall to about 22 cents, fully franked. At 22 cents, the new expected yield (at $4.40) was 5%.
So, if an investor, John Smith, bought 100 shares in Telstra in May 2017, paying $4.40 a share, he could have expected a dividend of $31. In reality, John Smith’s return was $22.
Dividends are the same as the money you earn from work – cash delivered to your bank account with no restrictions on how you use it.
You can spend it or save it in a savings account or term deposits. Or you can invest it.
In some instances, you can opt into a dividend reinvestment plan, whereby the dividend proceeds are used to automatically purchase more shares in the same company that paid out the dividend. It allows investors to compound their returns over time by accumulating more shares, which in the future pay dividends, that are again reinvested.
The bottom line on dividends is that they are income for investors and should be treated with as much care and consideration as any other income source. A financial adviser is a great place to start if you’re looking for some help.