Author: Marissa Hayden
Here’s a look at how dividends work and the pros and cons of investing in companies that pay them.
How do dividends work?
Put simply, when you purchase a stock in a company you become a part-owner of the business, and dividends are your share of the profits.
However, dividends are not compulsory and not all companies pay them. When a publicly held company makes a profit, the board of directors decides where the funds will go. Either the company retains the profits to invest back into the business, or the decision is made to pay out dividends to shareholders.
Sometimes, it can be a mixture of both. When NZX-listed companies decide to pay out dividends, they generally do so biannually. And this cash payment is usually a percentage of the profits relative to the number of shares you own in the company.
For example, let’s say that company XYZ makes a $10 million profit. The board decides to pay out 70% ($7 million) of the earnings and retain the remaining 30% ($3 million) for business expansion. The company has 1 million shares on issue. Therefore, each shareholder is entitled to receive a dividend payment of $7/share.
If a company has had a particularly profitable year dividends may even be increased. Generally, dividends are sent to shareholders either via a cheque or transferred by direct credit.
Why do companies pay dividends?
Generally, companies pay dividends to attract investors and retain current investors. Paying dividends can be particularly helpful when share prices are declining or are stagnant, as it may entice new investors and, therefore, help to increase a company’s share prices.
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Types of dividends
There are three types of dividends that you will likely encounter:
Interim dividend: this dividend is typically paid to investors six months into the financial year. Not all companies pay interim dividends, and opt to pay just a final dividend instead.
Final dividend: typically, a final dividend is paid to investors at the end of a financial year, around the same time the company announces its profits for the year.
Special dividend: sometimes when a company has been particularly profitable, it may decide to issue a special dividend to shareholders. This is a bonus dividend that is not regularly paid and is often larger than normal.
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Why buy dividend stocks?
So, why would you choose dividend stocks over others? Probably the biggest advantage of investing in dividend-paying stocks is that it’s the most common way of profiting from a stock without selling it. This can make dividends particularly attractive for investors looking for an income stream from their investments. If an income stream is not your primary objective, then an alternative is to reinvest your dividends.
Additionally, when a company distributes dividends to shareholders this is seen as a positive sign for the company’s financial health. If a company can afford to pay dividends to shareholders then, in theory, it should be making a profit. Better yet, if the company has consistently increased their dividends, then they are likely to be a consistently profitable business. However, it is always best to pair this logic with thorough research and analysis.
What are the drawbacks of investing in dividend stocks
On the downside, companies that choose to reinvest their profits, as opposed to paying dividends may grow faster. Their profits can instead be used to expand the business, which over time may see the stock value of the company grow.
Also, dividends are not always guaranteed. If a company’s earnings fall, generally, so do its dividends. At any point, a company can choose to reduce or eliminate their dividends altogether.
The argument can be made that if you are looking for a steady income stream, a better option may be to invest in bonds instead. Generally less volatile than stocks, bonds commit to paying out a coupon (interest) to bondholders at regular intervals until the bond matures. Learn more about bonds here.
Should I buy dividend stocks?
Dividend stocks don’t suit all investors. Investors who are prioritising long-term wealth accumulation may want to focus on capital gains rather than on dividends. However, if you want to see results from your hard-earned cash sooner rather than later, you may want to consider dividend-paying stocks as part of your investment portfolio.
About the reviewer of this page
This report was reviewed by Canstar Content Producer, Andrew Broadley. Andrew is an experienced writer with a wide range of industry experience. Starting out, he cut his teeth working as a writer for print and online magazines, and he has worked in both journalism and editorial roles. His content has covered lifestyle and culture, marketing and, more recently, finance for Canstar.