Dividend Investing in Dividend Paying Stocks

A good value investing proposition?

Is dividend investing a good value investing idea? The following discussion will go some way to answer this question.

What are dividends? A definition of dividend is the cash paid out to shareholders that isn't retained by the company for reinvestment in company activities.

Dividend investing refers to investing in high yielding stocks whose earnings are passed on to shareholders.

This is usually as an interim payment after a half-year report, and as a final payment after the annual report.

In some countries there are monthly dividend stocks. The Monthly Dividend Directory™ lists over 400 stocks paying dividends monthly.


Dividend Re-investment Plans (DRPs)

These plans, offered by some companies, allow for the dividend received to be automatically re-invested in more stock.

This not only provides the company with more capital to re-invest, but it allows the investor to add to their stock holding in the company without having to pay brokerage.

Of course these plans raise the question as to whether the company should have held onto the cash in the first place if they needed it.

The reason being that the shareholder has to pay tax on the divided received, whether it is reinvested in the plan or not.


Dividends and Taxes

Dividends can vary from a few cents to a several dollars per share depending on the size and profitability of the company.

Records of payments need to be kept for tax reporting, and the way dividends are taxed varies from country to country.

If the dividend payments in a country are reported as franked, it means that the company has already paid company tax on the earnings.

Franked dividends, when they are available in a country, are more attractive as the 'grossed up' dividend yield magnifies the potential earnings.

For investors in Australia and some other countries, this means that the government is not 'double dipping' by taxing the company on its earnings and then taxing the investor as well when s/he gets the dividend.

The U.S. government does a taxation 'double dip', so companies have tended to reduce dividend payments and use a buyback strategy.

Reducing the supply of shares increases the earnings per share. This eventually rewards shareholders with an increased share price when they sell.

A qualified dividend is a type of dividend to which capital gains tax rates are applied. The qualified dividend tax rate is usually lower than regular income tax rate.

To qualify, certain conditions have to apply such as the dividend being paid by an American company and that the dividend holding period has been met.

In the USA, ordinary dividends that do not qualify for this tax preference are taxed at an individual's normal income tax rate


The Dividend Yield

The dividend yield is obtained by dividing the dividend by the share price and expressing it as a percentage.

The stock dividend yield may vary from one or two percent to nine or ten percent - or more.

'Growth' companies generally have low dividend yields and mature companies with low growth characteristics that generate large amounts of cash commonly have larger yields.

It is these low-growth companies generating large cash flows that are more suitable for dividend investing.

Stocks paying large dividends are commonly referred to as high dividend stocks, high-yield dividend stocks or simply dividend paying stocks. They are popular with people who are investing during retirement.

Retirees commonly look for high-yield dividend investing as this can result in tax efficient investing if the payments are fully franked.

The dividend stream becomes an alternative source of income.

For investors wishing to achieve diversification and also participate in dividend investing, a dividend mutual fund may be more suitable.

Dividend mutual funds concentrate on stocks paying good dividend yields.


Cautions about Dividends

Keep in mind that dividends are not guaranteed and are dependent on how much cash the company is prepared to pay out from its profits each year.

This payout is reported as the payout ratio that varies across companies from about 20 – 100%.

Companies may reduce their payout ratios during an economic recession in order to conserve cash and reduce debt.

Some companies don't pay dividends at all and choose to re-invest all the annual profits. This makes sense if they have a high return on equity e.g., above 15% as they can do more with your money than you can.

Also keep in mind that the highest dividend paying stocks are not necessarily the best value-investing opportunities.

Stocks with high dividend yields may achieve this position because their share price has dropped significantly for reasons that need to be investigated.


Dividend Strategies

How does dividend investing affect my buying strategy? I tend to invest in a mix of companies to achieve an average dividend yield of 4 to 5%, mainly fully franked. That is, dividends on which the company tax has already been paid.

This ensures that if the market becomes depressed, as in the case of a stockmarket crash, I am still receiving a reasonable return on capital until better times arise.

I may use some income from dividends to pay for the interest on a margin loan. The remainder I allow to accumulate in the investment account as capital for future purchases.

Because all my dividend income is not consumed paying for debt, I remain positively geared. That is, my dividend income exceeds my interest payments.

The earnings you receive as a shareholder consist of dividends and /or capital gain (increased share price). Of course, you have to sell the share to realize the capital gain, whereas the dividends will arrive as long as you keep the stock.

The best dividend stocks provide some capital growth as well as reliable dividend payments.

Companies that provide growth together with solid dividends are sometimes referred to as mattress stuffers - for obvious reasons!


The Dividend Double-Whammy

A little appreciated fact is that unlike interest payments from a bank, company dividends usually grow over time. This makes dividend investing more attractive.

The dividend growth rate provides a measure of the dividend increase.

Stocks paying dividends provide a double-whammy effect of growing dividends and growing share price – if all goes well.

History demonstrates that the most profitable stocks over the last 50 years all paid dividends.

That says something about a dividend investing strategy.

Also, historical studies of the long-term returns on shares indicate that, for U.S., British and Australian share markets, dividends account for some 50% of returns.

Hence you ignore dividend investing as a powerful generator of capital returns at your peril! Dividends are a vital part of the overall return from the stock market.

“A cow for her milk, a hen for her eggs, and a stock, by heck, for its dividends.” - John Burr Williams.

To hammer, or whammy this into your cerebral cortex a little further, it is pleasing to know that dividends are two to three times less volatile than share prices.

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A focus on dividends is less stressful than a focus on growth!

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To Pay or Not to Pay Dividends

Company directors are aware that they don't win shareholder popularity contests by lowering dividends.

It needs to be kept in mind that for companies exhibiting a high return on equity (ROE), a large proportion of profits are better re-invested in the company rather than being distributed to shareholders.

This particularly applies if the dividends are not fully franked(not all the company tax has been paid).

Companies with high return on equity are in a better position to utilize profits to increase value if the re-invested profits can be compounded at a high rate over a number of years.

Conversely companies with low return on equity should be distributing most of their profits to shareholders as re-investing earnings will result in the erosion of value unless their return on equity can be raised.


Dividend Terms

Some other terms associated with dividend investing include cum-dividend, ex-dividend and record date. You will see or hear these terms when a company declares a dividend ...

• Cum-dividend means the shares carry the entitlement to the dividend and if purchased 'cum-dividend', the buyer will receive the dividend.
• Ex-dividend means without the dividend. Therefore if you see a company’s share price quoted 'ex-dividend', the dividend is earmarked for the seller, not the buyer. The ex-dividend date is usually advertised through the relevant stock exchange in an ex-dividend calendar, or in the financial press.

  The market price will reflect whether the shares are 'cum' or 'ex' the dividend entitlement.

  Ex-dividend dates are commonly provided by the company, by the relevant stock exchange, or by the financial press. The dividend ex date is the date when the stock no longer attracts the dividend.

• Record date is the date used to determine which shareholders are on the register. The number of shares they hold on that date determines the size of their dividend.

  It is the date where all changes to registration or banking details must be made for them to receive the dividend payment.

To Conclude

So is dividend investing a good value investing idea? Like a lot of questions, the answer is - it depends!

Dividends can represent up to 50% of the return on an income portfolio, especially in countries where dividend payments tend to be higher than elsewhere and franking credits apply.

But I am not at all concerned if a company with a high stable or increasing return on equity is re-investing most of its earnings in the company. I am likely to be on a winner!

So while dividend investing is a good strategy to produce a healthy cash flow, there are other reasons why I might choose stocks that are holding on to their earnings, rather than giving them to me as dividends.

The related articles below examine dividend stripping and the importance of return on equity in relation to dividend payouts.

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Related Articles

Dividend stripping - involves buying stock just to reap the dividend (and franking credits if they apply) in order to enhance your investment returns in the short term. But what are the risks?

Return on equity (ROE) - Companies that exhibit a high return on equity may provide more benefit to shareholders by re-investing profits in the company rather than paying out the profits as dividends. Find out why!

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