Before I joined the Money Morning team, I spent the previous 20 years in a number of roles. I traded on the Sydney Futures Exchange, I spent time working as a private trader, and I also worked for a UK derivatives firm in Melbourne.
During that time, I’ve gotten to know a lot about what works — and what doesn’t — in investing. One of the biggest things I’ve learned is that many investors are so busy looking for the super exciting investments that they forget about the basics; such as trying to earn an income from their investments.
How to boost your income using dividends
With little prospects of interest rates rising anytime soon, the search for income continues amongst investors. Bank economists and brokers are now predicting the next move in the official cash rate in 2016 is heading down.
While lower interest rates are welcome to homeowners with variable-rate mortgages, it has the opposite effect for those relying on savings to earn an income. The interest earned by cash savers has now dropped to a level where they need to look at other asset classes to supplement existing income streams.
One such asset class where investors seek this additional income is through the share market. When an investor buys shares, there are two ways to make money:
- Capital gains
- Income (dividends)
Some investors will trade shares purely for capital gains, whereas someone who needs an income from their investments may focus on shares that produce an income. Companies that have a history of paying regular, and increasing, dividends are viewed favourably among this type of investor.
But, before we go any further, just what is a dividend?
How companies pay out dividends
When a company makes a profit, having fulfilled its tax obligations, its management will decide how best to use the leftover cash.
First, they’ll decide how much cash the company needs to retain in order to grow the business. Second, they’ll work out how much of the remaining cash they can afford to pay out to shareholders.
Once they’ve decided, the company will declare a dividend, including the record date. Any shareholder on the company’s register by this date is eligible to participate in the upcoming dividend.
You’ll also see references to an ‘ex-dividend date’. This is the first day of trading in which the buyer misses out on this dividend. Typically, a share price drops when it goes ex-dividend to reflect this. So if you want to participate in a dividend, you need to make sure you buy shares before the ex-dividend date.
For example, if a company declares a dividend of 20 cents per share, a shareholder who owns 1,000 shares by the record date will receive a dividend of $200.
The company will pay the dividend either directly into the shareholder’s bank account, or by sending a cheque to their nominated address. Note that some companies will only pay dividends directly to a bank account. If you haven’t nominated a bank account, they’ll hold onto the dividend until you send them your bank details.
As an alternative, some companies offer a Dividend Reinvestment Plan (DRP). This is where a shareholder can choose to receive shares instead of the dividend cash amount. To encourage shareholders to take up the DRP (allowing the company to retain cash in exchange for new shares), the company will often offer these additional shares at a discount to the current market price.
Another bonus to the shareholder under the DRP is that they don’t need to pay brokerage to take up their allocation of shares.
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Another important thing to consider with dividends is the use of dividend imputation, or franking credits.
Dividend imputation avoids double taxation. First, of the company’s profits. And second, by taxing the same ‘profits’ again when received by shareholders as dividends.
The benefit of this is that the tax the company has already paid can be passed on to the shareholder. In effect, if a shareholder’s marginal tax rate is at, or below, 30% (the current corporate tax rate) the shareholder won’t need to pay tax on a fully franked dividend. They may even qualify for a partial tax refund.
If their marginal rate is above 30%, then they’ll only have to pay tax on the difference between their marginal rate and the corporate tax rate. Of course, as with all investments, you may wish to consult your tax specialist prior to investing.
Share price action around dividend time
Once investors know a company is about to pay a dividend, they will be keen to buy shares so they too can claim a share of the profits. It’s quite common, therefore, to see the share price rise up until the day before the ex-dividend date (this is the last day that investors can buy the shares to qualify for the dividend).
Once this date has passed, the share price will typically fall by roughly the value of the declared dividend. This price pattern can be useful when trying to time the share purchase.
How to choose the right dividend paying share
There are a number of things to look for when deciding which dividend-paying shares to buy. Although a company’s dividend history doesn’t guarantee its future distributions, it can often act as a guide. The key things to look for are:
1. Dividend Yield — expressed as a percentage, this is a calculation of the total dividends paid out over the last year in relation to the underlying share price. For example, a company that is trading at a share price of $50, and has paid out $5 in dividends over the past year, has a dividend yield of 10%. The Dividend Yield can be a handy place to start, but on its own won’t tell you everything.
It’s also important to understand that the dividend yield is based on the last 12 months. That is, it’s historical. It doesn’t guarantee that those past dividends will be paid out in the future. Quite often, a really high dividend yield infers that the dividend might not be sustainable.
2. Stability — we also want to know if the company pays a dividend regularly. Most blue chip companies pay out two dividends each year — an interim, and then a final, dividend. A company that has a long history of paying consistent dividends is going to be more valued than a company whose history of payments is sporadic.
3. Growth — here we look to see a history of dividends increasing over time.
On a more general level, you also want to assess the sector the company operates in; and the overall market as well. For example, an energy stock may have a strong history of paying dividends, yet the oil price may have dropped dramatically since it paid out its last dividend.
There is an increased chance, under this scenario, that the company may need to cut the size of the dividend it intends to pay shareholders.
How does a dividend payout happen?
On 10 February 2016, Commonwealth Bank [ASX:CBA] announced that it would pay an interim dividend of $1.98 per share. This dividend is fully franked; shareholders need to be on the CBA share registry as at the record date, 18 February 2016, to be eligible. The ex-dividend date was 16 February, meaning that any shares purchased on or after this date are not entitled to this payment. The payment is disbursed on 31 March 2016.
A CBA shareholder who owns 500 shares as at the record date (18 February in this case) receives $990 in their nominated bank account fully franked. (That’s 500 x $1.98.)
How is the dividend yield calculated?
In the Commonwealth Bank example above, the bank paid a final dividend of $2.22 per share on 1 October 2015, and then the $1.98 interim dividend on 31 March 2016, giving a total dividend payout for the last 12 months of $4.20. To calculate the yield, we divide this into the current share price and multiply by 100 to make it a percentage.
So in this example, if the share price was $75, the yield is $4.20/75 x 100, which gives a 5.6% yield.
Note: It is important to remember that the yield changes as the share price changes. In effect, the yield increases as the share price goes down, and decreases as the share price goes up.
Some examples of dividend paying stocks
To give some current examples of shares that may be included in an income focused portfolio, let’s look at the table below:
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|Company||1st Dividend||2nd Dividend||Total dividend||Yield (share price as at 23 Feb 2016)|
Though not necessarily current recommendations, a diversified portfolio of financial, defensive and cyclical industrial stocks can form the basis of an income based portfolio. Although yield is important, remember that there are other criteria that we need to consider. Such things include dividend growth and stability and, on a more general level, the market conditions and the sector the share belongs to.
Two shares that have grown their dividends consistently over time
Two companies that have grown their dividend consistently over time are Transurban [ASX:TCL] and AGL Energy [ASX:AGL]. Let’s look at the tables below:
|Year||Interim dividend||Final dividend||Total dividend|
|Year||Interim dividend||Final dividend||Total dividend|
This type of dividend growth and stability are valued by investors looking for income producing shares. To find out about a company’s dividend history, go to their website and look for ‘Investor Centre’. Here they will have their dividend paying history.
How to find dividend information
There are many places where you can find information on dividends. These include, but aren’t limited to:
- Free websites such as Google Finance and Yahoo! Finance, both of which are useful source of information on company dividends.
- Company websites — for example, the Commonwealth Bank website has all their dividend history going back to 1991, including the company’s dividend policy and their payout ratio. The payout ratio tells you how much of the company’s profit (after tax) they pay out to shareholders.
- Newspapers still have a lot of information, including recent price action, the high and low of the past 12 months, dividend yields and net asset backing. This can be a good place to get a feel for how much different companies, from varying sectors, pay out in dividends to their shareholder base.
As with all investments there are associated risks, so it’s important to gather as much information as you can before you start to invest.
A well balanced and diversified portfolio of shares should be more resistant to market movements than allocating all your funds into just a few shares. When investing for income, do your homework and be patient, as your goal is to generate regular consistent income for the long term.
While many people don’t find this kind of thing exciting, investing for income is just as important, if not more important, than speculating. That’s why I devote every working hour of the day to looking for quality income-paying stocks.
Income Specialist, Money Morning