Smart Investor: Understanding Dividends

Smart Investor: Getting Started – March 2011

Last week we looked at setting up a brokerage account and buying shares. Once you’ve done that, one of the things you’ll need to keep track of – and one of the big considerations in deciding what shares to buy in the first place – is dividend payouts.

Australia is known as a high-yielding market. That means that, among big stock markets around the world, Australia is one where dividends are particularly important, and usually relatively generous.

Dividends are a way that companies reward shareholders by distributing their profits. Often this happens twice a year: a full-year dividend, decided at the end of a company’s financial year; and an interim dividend, at the halfway point. A company’s dividend relative to its overall share price is called the yield, and is expressed in percentage terms.

Companies vary widely in terms of their dividend yield: some, particularly those keen to grow, pay a low yield of around 2% (and during the financial crisis may have canned their dividends completely), because they want to keep their profits in the business in order to finance expansion. Others, particularly things like listed property trusts (also called real estate investment trusts), might pay a much higher yield, potentially as much as 10% – although at a level like that you’d have to wonder if it’s sustainable.

Dividend yields are frequently published in publications like the Australian Financial Review, and will very likely be available through your broker too. Some investors base their entire investment policy on dividends, and some retirees live off that income. Deciding on your stocks in this way is known as an income portfolio, in that the main thing you’ve looked for is steady dividend income rather than capital growth.

Once you hold a share, you’ll be notified about dividends when they are announced. Often you will be given a choice between receiving a dividend as a cheque, getting it put directly into your bank account, or sometimes opting for a dividend reinvestment plan – a handy approach in which all your dividends are used to buy more shares.

For example, I recently received a dividend statement from Incitec Pivot. This told me a few things. For a start, it states the payment date (when I get my money – December 17), and the record date (November 24). This tells you the date on which it is decided if you are entitled to a dividend or not: if you hold shares on the record date, you are; if you buy afterwards, you’re not. The period after a record date is known as a stock going ex-dividend, and it often trades down a touch at that time.

My statement also tells me the dividend rate per share (expressed in cents), how many shares I own, whether the dividend reinvestment plan is still running (in this case it’s been suspended), and also whether the dividend is franked or unfranked.

In a high-tax country like Australia, this is very important, and a large part of an investment decision. If a company has already paid tax on its profits – through company tax – then there’s no need for you to pay tax on it again. This is known as a franking credit, and the company can pass it on to you, allowing you to receive a tax offset on your own bill. This benefit is sometimes expressed as a grossed-up yield: a percentage that takes into account the value of the franking credits.

The difference between a dividend being franked or unfranked can be quite significant, although the way it affects you will depend on your own tax rate and should be discussed with an advisor. It is possible, for example, for a stock to have a cash dividend yield of 5.6%, a grossed-up yield of 8% and an after-tax yield of 4.4% – yet it’s all the same company and the same dividend. Franking apart, your income in dividends is liable for income tax just like any other earnings you make.

Anyone buying shares for their dividends needs to be comfortable with a few things. The main one: if a yield is high today, is it likely to remain so tomorrow? Ask yourself how and why a company is paying out a big yield. Property trusts tend to pay high dividends because they have a constant, reliable rental income from the properties they hold. Conservatively run trusts are therefore likely to carry on doing so. But some companies might have a high yield in percentage terms just because their share price has fallen sharply – which means, in percentage terms, their dividend yield has gone up even if the dividend itself in dollars and cents hasn’t moved (see box). Data at the ASX allows you to check a company’s dividend history.

BOX: Talking Dividends – Telstra

Many investors hold Telstra as a yield stock. For many years it has paid a consistently high dividend. But let’s take a closer look.

On CommSec’s numbers on January 17, Telstra paid a fully-franked dividend of 9.8%, or a tax-adjusted dividend of 7.7%.

That’s exceptionally high, and much higher than it was, say, last July. But this is an example of a time when it pays to take a closer look at what’s happening. Telstra’s last dividend was 14 cents per share, with a payment date of September 24. The previous two (March 26, and September 25 2009) were also 14 cents per share – so in real money, the dividend hasn’t changed at all. What’s changed, though, is Telstra’s share price. Early last August it stood at just over $3.30 per share, but by late November was below $2.60 before rallying since. When a share price falls, and the dividend in cents per share stays the same, the dividend yield goes up – but you’re not actually getting any more money.

That said, some feel that it does present a buying opportunity. If you buy Telstra now for its exceptionally high dividend, it’s very likely that the dividend yield will decline in the year ahead – but if it does, it’s because the stock has rebounded, and that means you’ve experienced capital growth. All these things have to be considered together rather than just jumping on a stock because of an attractive-looking number.