Dividend occurs when a company make a profit and passes that profit to its shareholders. The board decides the dividend policy on how much of the profit is paid out. Companies declare dividends during the interim and final results. Dividends are paid out every 6 months as interim and final dividend.
Dividends are usually paid in cash but it can come in the form of equivalent value in its own shares. In these instances either company wants to preserve cash and at the same time shows it is passing value to shareholders (market is skeptical of share dividends).
It can be argued if this is really true value distribution or just a quick way of issuing more shares masked as dividends.
Over the long run, value can be created by participating in the dividend reinvestment plans or DRP. The advantage of taking dividends in stock is it gives investors the benefit of power of compounding on its investments as today’s share dividends will be eligible for next periods dividend as well.
Dividends Payout Policy
There are a number of ways the board of directors decide how much of earnings should be paid as dividends.
Below are some of the most common dividend policies used by companies
- Fixed dividend policy – total dividends paid is stable year in and year out irrespective of profit cycle
- Target payout ratio – targeting specific portion of that years profit as dividend
- Residual dividend – all profits after required capital expenditure is distributed to shareholders.
Dividend Payout Ratio
The ratio is defined as dividends divided by earnings. It shows the total proportion of reported income distributed to shareholders. Mature and stable income shares like Banks, Insurance and REITs usually have higher payout ratios and rarely drop dividends.
Investors looking for dividend growth can focus on low payout companies that have strong profit growth. Overtime, the board of these companies usually shift the payout policy in shareholders favour which means faster than normal dividend growth.
Dividend Impact on Long Term Returns
Research shows that shares that pay dividends has outperformed non performing dividends. Typically dividends are declared when the board recognizes the sustainability of the current earnings as well as confidence in future profits.
Dividends can come in form of franked and unfranked form. Domestic Australian investors do not pay taxes on Australian company dividends. A portion of dividends paid to foreign investors are withheld through the dividend withholding tax.