How do dividends work?
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, not all companies pay dividends. 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 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.
Types of dividends
There are three common types of dividends:
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.
Why buy dividend stocks?
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's 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.
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.
How do dividends work in ETFs?
ETFs pay dividends the same way any dividend-paying stock would, but there are some points you may want to consider if high-dividend yield is a key focus in your investment strategy.
The different types of ETFs
There is a range of ETF types that you can choose from when investing. To summarise:
- New Zealand or International Broad Based ETFs track a broad index (eg. the S&P/NZX50) either in New Zealand or internationally, respectively
- Sector ETFs invest in a particular sector, for example, materials, property or healthcare
- Strategy ETFs focus on a particular investment style or strategy, such as maximised capital growth, or defensive assets
- Commodities focus on physical commodities, like gold or other precious metals or agricultural goods
- Currency-ETFs track how the NZD is performing against other currencies
Dividend ETFs fall under the strategy category.
How often do ETFs pay dividends and how do payments work?
Typically, ETFs pay out dividends quarterly. Any stocks within the portfolio that pay out a dividend have these payouts pooled together. Like individual stocks, these dividends may be in the form of cash payouts, or issuance of further stocks.
The amount an investor gets in dividends depends on how many shares of the ETF they own – for example, if 1000 shares of an ETF are available and a single investor owns 10, then they would hold 1% of the portfolio, and thus be entitled to 1% of dividend payments.
The different types of dividend ETFs
Dividend-ETFs fall under the Strategy Based ETF category, but there are several more subcategories of dividend ETFs. These range from high dividend yield, to dividend aristocrats, hybrid dividends and more.
If an ETF fund manager's primary goal is investing in ETFs that will result in high/frequent dividend payouts, they have a couple of options. They may invest in companies that have long records of paying high dividend yields, such as dividend aristocrats. This is the more conventional approach to dividend-focused strategies.
Alternatively, managers may opt for a dividend harvesting strategy. Dividend harvesting is particularly popular amongst day traders, and involves purchasing stocks as they are about to pay out dividends, before reselling them.
Pros & cons of dividend-paying ETFs:
Pros:
- High-yield dividend ETFs may be a way for investors to access income, especially at times when interest rates are particularly low
- Low cash rates typically affect dividend ETFs less negatively than property/fixed income ETFs
- ETFs, in general, typically provide greater diversification, which can help hedge risk
- Investors don’t have to worry about tracking stocks, as this is handled by the ETF index or a fund manager
Cons:
- In passively managed dividend-ETFs (and sometimes actively managed ones) stocks are often sold when there are dividend cuts, so stocks may be sold when the price is lower and at other inopportune times
- Annual costs, especially on actively managed ETFs, may be higher
- Investors have no input on what the ETF contains, stock-wise. They may choose the strategy/theme but day to day, stock decisions are determined by the manager of the ETF