Dividends and Dividend Reinvestment Plans
By Dale Gillham | Published 26 November 2018
Over the decades that I have been helping traders and investors, one of the more common questions I get asked is: What do you think about this stock? The reason this question comes up is because, more often than not, the individual asking is losing money. In response to this question I always ask: Why did you buy it and the answer is because it pays a good dividend.
But is investing for dividends and using dividend reinvestment plans the best strategy to apply in the stock market? I would argue that you shouldn’t buy stocks on dividends alone. A good investment must have capital growth, whereby your investments appreciate in value, and income from dividends. While both are equally important, depending on your circumstances and where you are in your life, you may place more emphasis on one or the other. That said, I teach traders and investors to develop a strategy that combines both using my four golden rules to investing in shares, which I outline in detail in my latest book Accelerate Your Wealth, It’s Your Money, Your Choice.
So let’s take a look at what dividends are and why you would consider using a dividend reinvestment plan in your portfolio.
What is a dividend?
When you purchase shares in a company, you are entitled to receive a portion of the profits in the form of a dividend. How much you get paid will vary widely, therefore, it pays to check the company’s dividend policy before purchasing shares to ensure it fits with the goal of your portfolio. For example, if your goal was to purchase shares that deliver both growth and income, then purchasing a small-cap stock may not deliver the outcome you are seeking, as it may not pay a dividend.
Companies usually pay dividends twice a year, although depending on the company’s policy, they can pay more or less frequently. You can find out when a company pays its dividends by visiting the stock exchange or by going to the company’s website.
When are you entitled to a dividend?
Each dividend has a record date and an ex-dividend date associated with it. The record date is the date the company closes its register to determine which shareholders are entitled to receive the current dividend, while the ex-dividend date falls one business day before the company’s record date. To be entitled to a dividend, you must have purchased shares in the company before the ex-dividend date.
How to calculate a stock's dividend yield
There is no set formula as to how a company will calculate the percentage of profits they will pay as a dividend, as there are many factors that are taken into account, which is why this is largely irrelevant. What is important is to understand how to calculate the dividend yield you will receive.
A company's dividend yield is calculated as the income you receive from holding the shares expressed as a percentage of its current market price. Therefore, the dividend yield equates to the annual dividend per share divided by the current share price multiplied by 100.
For example, if you purchased shares priced at $1.00 and the company paid a dividend of 10 cents, its dividend yield would be ten cents divided by $1.00 multiplied by 100, which equates to 10 percent.
Therefore, when you purchase shares in a company, you secure the price at which the dividend yield is calculated because your entitlement to a dividend is based on the price you paid for the stock.
So what if the price of the stock you own rises to $2.00 and it still pays a dividend of 10 cents per share? The dividend yield would now represent 5 percent based on the current stock price, but your dividend yield would continue to be 10 percent because you purchased the shares at $1.00.
Interestingly, as the price of a stock falls, its dividend yield generally rises and, therefore, becomes more attractive to investors seeking dividends for income. But some would have you believe that a high dividend yield means the stock is cheap and an opportunity to achieve good capital growth. Unfortunately, this is only true once the stock stops falling. On the whole companies that have a history of paying good dividends are profitable. Therefore, I recommend identifying companies that pay a good dividend yield and are falling in value, as they may alert you to stocks that will eventually turn and start to rise once again, so you get both income and capital gain.
What are dividend reinvestment plans?
Many companies also offer dividend reinvestment plans, which allow you to use the money you would normally receive as a cash dividend to purchase additional shares in the company.
The main advantage of a dividend reinvestment plan is that it compounds your returns because you are reinvesting your earnings. It is also a very effective form of forced savings, provided you know how to protect your capital if the stocks turns and starts to fall away.
How does a dividend reinvestment plan work?
Shares are usually issued at current market prices, although sometimes they are offered at a discount. In most cases, you can nominate whether all or part of your shareholding is included in a dividend reinvestment plan. The good news, if you decide to reinvest your dividends, is that the shares are acquired without having to pay any brokerage, commission or any other transaction costs. But the shares will be subject to capital gains tax because the revenue office views it as if you had received a cash dividend and then used the cash to buy additional shares. Let's look at an example of how a dividend reinvestment plan works.
Joan owns 1500 shares in XYZ Ltd and the shares are currently trading at $15 each. In October 2018, the company declares a dividend of 20 cents per share. Joan could either take the $300 dividend as cash (1,500 × 20 cents) or receive 20 additional shares in the company (300/15). Joan decides to participate in the dividend reinvestment plan and receives 20 additional shares in December 2018.
Once you receive a dividend payment, the company will issue a statement detailing the allotment of shares you received as part of the dividend reinvestment plan. You should ensure you file this statement with your contract notes, so that you have all of your records available when preparing your tax return.
Should you reinvest your dividends?
Whether or not you reinvest your dividends will depend on your investment goals. For example, if you choose to operate a growth portfolio, it makes sense to reinvest your dividends so that you compound your returns. However, if you are operating a portfolio to generate income, then you would take the dividends as a cash payment. This is more common for retirees, who may not necessarily need capital growth and would prefer extra income to support their lifestyle.
Interestingly, dividend payments are often more attractive for retirees than receiving rental income from properties for two reasons: firstly because the dividend yield on many stocks is higher than the rental yield on a property, and secondly, when you factor in the costs of maintaining the properly, many find the net yield is very low.
But what if you would prefer to receive the dividends as income, rather than reinvest them – the question is what should you do with the cash? I strongly recommend you use it to fund other investments.
For example, you could take the money and place it in an interest bearing account to build up a deposit for a home or use it pay down your home loan much quicker. Alternatively, you may want to use it to purchase other stocks so as to build up your portfolio. Either way, the important point to remember, as I outline in my article on the laws to wealth creation, whatever you earn from your investments must be reinvested into other assets so that you continue to compound your returns.
So there you have it, all you need to know about dividends and dividend reinvestment plans.
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