What is dividend investing?

What is dividend investing?

Dividend investing is the process of investing in the shares of companies that pay out a regular dividend to their shareholders. Dividends are regular sums paid out based on a company's income and are calculated as a yield return.

Not all companies pay out a dividend, so those that do – and provide high yields and the potential for share price growth – are popular among investors. However, these can be difficult to find. A dividend yield is calculated as a percentage of the share's price.

Dividend growth investing can offer strong returns when used as part of a wider investing strategy. But remember – past performance doesn't guarantee future returns.

Dividend payments are also not legally required of a company. This means it's never a certainty that a company will pay out a dividend, even if it has a strong track record of doing so. A company's ability to pay a dividend can be affected by several internal and external factors, like its profitability in the year prior to an expected payment, its own investment plans and the wider availability of funds.

Why reinvesting dividends is key to long-term returns

There are two key ways to make money from investing in shares. The first depends on the capital returns from share price appreciation. This is the most popular way for investors to try to make money. The second comes from income returns when companies pay out dividends.

A way to maximise returns from the latter is by reinvesting those dividends back into the company. This creates the potential for a compounding effect. When dividends are reinvested, they are used to purchase additional shares of the same stock. In turn, this increases the potential for future dividend payments.

Compounding dividends can significantly enhance your investment returns over the long term. By reinvesting the dividends, you're earning returns on your initial investment as well as on the reinvested dividends. This compounding effect allows your investment to grow faster than if you were to take the dividends as cash and rely only on share price growth for more returns. This, of course, assumes that the cash received in dividends isn't reinvested in other assets that may provide a return.

Suppose you have invested $10,000 in a share that pays an annual dividend yield of 5%. In the first year, you'd receive $500 in dividends ($10,000 x 0.05). Instead of withdrawing this $500, you decide to reinvest it by purchasing more shares of the same stock.

Let's assume the share's price is $50, therefore, you can buy 10 additional shares of the stock ($500 / $50). Now, you own a total of 210 shares in the company, instead of your original 200 shares based on the initial $10,000 investment.

In the second year, the share price increases to $55, and the company maintains the same 5% dividend yield. As a result, you would receive $577.50 in dividends ($11,550 x 0.05). Again, you choose to reinvest this amount by purchasing additional shares, which would be approximately 10.50 shares ($577.50 / $55). Now, you own around 220.50 shares.

This process continues year after year, with your dividend payments being reinvested and buying more shares. Over time, the compounding effect starts to accelerate, and your investment grows exponentially.

Advantages of dividend investing

• Can increase returns from share investing

Dividends can add a premium to the classic approach of investing in shares. For example, 75% of the returns from the S&P 500 from 1980 to 2019 came from dividends.¹

• Provides extra metrics for fundamental analysis

An investor using fundamental analysis, factors in many metrics to make a decision on a company's value. Dividends represent an extra indicator because they can demonstrate a company's ability to generate cash flow over time and that the company isn't heavily indebted.

• Reduces overall portfolio risk

Dividend shares can be less volatile than other shares, due to the fairly consistent demand for them and the offset value of dividends should the share price of a share contract. This means an investor can balance it out against riskier, non-dividend-paying shares that might offer higher share price appreciation.

• Potential tax advantages

Dividends from ASX-listed shares can be unfranked and franked. An unfranked dividend is when the company hasn't paid tax on its earnings before distributing a dividend. A franked dividend is when the company has already paid tax on its earnings before the dividend is allocated. So the dividend amount isn't taxed twice, investors can claim the full franked amount as a tax offset in their tax return, reducing their overall tax liability.*

• Investment can potentially outpace inflation

Inflation is one of the key comparative metrics an investor looks towards to make sure their investment is making money. Ideally, an investment should grow faster than inflation, but that's not always the case. Dividends can help increase investment returns relative to the inflation rate.

For example, say inflation grows at 3% but your investment grows at 2%. Your investment is now worth less. Now, imagine your investment grew at 2% but also offered a 3% dividend yield. It has now outpaced inflation, and your purchasing power has grown.

• Even during periods of recession, dividend shares have historically shown growth

Dividend shares can serve to mitigate the impact of a recession. While recessions typically hurt shares, blue-chip shares that pay dividends have generally been less impacted in the past.²

This is, in part, due to the sectors that typically pay dividends - like energy and utilities - being more recession-proof. It's also because investors often flock to dividend payers for more secure income.

Disadvantages of dividend investing

• It's a long-term investment

Because dividends are more effective when reinvested for compounding, it can take years for an investor to enjoy noticeable returns from this strategy. Dividend investing usually requires patience, so it isn't generally an effective strategy for a short-term investment horizon or day trading.

• Can be less profitable

Dividend shares typically don't see their share price appreciate as quickly as non-dividend-paying shares, including those in the same industry. This can be because growth shares are often more popular during a bull run, while dividend-paying companies may lose out from not investing those dividends in innovation instead. This leaves an investor susceptible to missing out on larger share price gains evident in growth shares, which might outweigh returns from dividends.

• It might not produce more than 10% annually

Even with the boost of a dividend yield, dividend shares don't tend to produce more than 10% growth annually. Over the long run, investors may be surrendering higher returns for the security of a dividend payment.

Companies that don't offer dividends are often reinvesting in the company's growth instead, which can offer higher returns over time relative to dividend shares.

• Dividend payments aren't mandatory

Because dividends aren't a legal requirement for companies, they can choose to stop paying them out at any time. This increases insecurity from a dividend investing strategy. However, most major companies avoid getting rid of dividends due to their attractiveness to investors.

How to research shares for dividend investing

Dividend investing requires plenty of research to ensure you're well-informed about your share picks, particularly in regard to a company's profitability and its potential to consistently deliver dividends over time.

Check to see if the company has demonstrated long-term profitability

When vetting dividend-paying companies, long-term profitability is a key consideration. Although any company can occasionally experience a profitable quarter, those that have demonstrated consistent growth on an annual basis might be more likely to consistently pay out future dividends.

Find companies with healthy cash flow generation

Most dividend payments come from a company's positive cash flow. You can calculate a company's free cash flow to equity to determine a suitable investment.

Avoid companies with high debt

Companies that have high debt are more likely to struggle with achieving the liquidity necessary to consistently pay out dividends because of the need to re-service their debt. The uncertainty of interest rate changes also adds to the risk that dividends might not be paid out consistently.

Check sector trends

While an investor might lean on certain sectors known for paying dividends, this alone shouldn't act as a strategy for picking shares. For example, energy shares are known for their regular dividend payouts. But if wholesale oil prices fall, this hits the profits of those companies as supply outweighs demand. This can weigh on cash flow and, accordingly, companies' abilities to pay out dividends.

When and how to receive your dividend payments

Companies typically pay out dividends on a quarterly or bi-annual basis. This information is usually declared alongside their financial results, with a date for payment set in the near future. Companies will often give an outlook for annual dividends alongside this announcement.

If you want to receive a dividend payment, you need to buy shares before a company's 'ex-dividend' date. You won't receive the dividend from investing in the share on or after this date.

You can choose whether to withdraw dividends. use them to fund other investments or reinvest them into the same company shares.

Dividend reinvestment plans (DRIPs) enable reinvesting of any dividends for compound returns over time. When you trade with us, your dividend won't be automatically reinvested, but you can choose to reinvest the dividend you receive back into the company by buying more shares with the cash proceeds.

Investors can also choose their preferred method of receiving dividends through their brokerage account or by contacting the company's share registry. If you opt to automatically reinvest dividends with a broker, it usually comes with a charge.

Dividend investing: things to look out for

Just like any investment activity, there are factors to consider with dividend investing. These include:

• Commission fees

Frequent contributions can lead to high transaction costs when investing in dividend shares. If an investor pays significant commissions for every investment, it can eat into the overall returns, especially when dealing with small dividend amounts.

• Dividend yields

It's important to not only focus on a share's dividend yield when investing. Companies that pay higher yields may be more financially strained, putting them at risk of consistently paying that rate out. It's crucial to evaluate the sustainability abd growth growth potential of a company and it's dividends, along with other fundamental factors, to make sound investment decisions.

On the other hand, not accumulating enough dividend income can hinder an invertor's ability to reinvest regularly. If an investor doesn't accumulate enough dividend income to purchase additional shares, the benefits of compounding can be limited.

• Tax obligations

Dividends received from investments are generally subject to taxes. In most cases, you are liable to pay tax on the full dividend amount received at your personal tax rate. Some investors may overlook or underestimate the tax implications of dividend income, potentially resulting in unexpected tax obligations.*

Types of dividends

• Cash dividends: when a company pays its shareholders in cash payments (typically half-yearly but can be an annual payment)
• Stock dividends: when a company rewards a shareholder by increasing the number of shares the said investor owns. These are not taxed until a shareholder sells them, so they can be quite attractive to investors*
• Scrip dividends: when a company can't afford to pay dividends at that current time, they will use a scrip. This is essentially a promissory note to say that they will pay the dividends at a future date (sometimes these can include interest)
• Property dividends: though rare, some companies can pay dividends in the form of assets or inventory to shareholders
• Liquidation dividends: the type of dividend paid to shareholders during a partial or full liquidation

How to invest in dividend shares

You can invest in dividends with us using the following steps:

1. Create your live account
2. Choose share trading
3. Make sure you do further research on how to diversify your portfolio and manage your risk
4. Fund your account

Dividend payments from owning shares will be credited to your IG account. This usually occurs within one day of the dividend payment date. You can then choose to reinvest the amount or withdraw it.

Dividend investing summed up

• Dividend investing is the process of investing in shares that pay out a dividend
• One way to make gains from dividend investing is to reinvest dividends back into the company to compound returns over time
• Before investing in a dividend-paying company, it's often useful to check its history of profitability and cash flow, as well as its level of debt
• To receive dividends in a company, you need to invest in it before its 'ex-dividend' date
• There are several types of dividends you can receive, including cash, stock and scrip dividends

¹ U.S. News, 2023
² The Motley Fool, 2023