What are Dividends ?
You can separate the layman, investor and fund manager from how they describe their investments. The layman will refer to their holdings as “stocks”, the investor “shares”, and the fund manager “equities”.
If you are unsure what dividends are, this post will be a light introductory read to get you up to speed.
I will briefly talk about investing for dividends, and focus on what I really want to talk about in the next post which is franking credits.
Dividends are cash payments from companies to its shareholders. I believe there are multiple resourcesavailable on this topic is so I will just mention the important stuff.
All dividends come from companies, but not all companies pay dividends. Payments from profit from companies to shareholders are known as dividends, whilst the term distribution applies to payments from trusts to unit-holders.
A dividend paying company is like an egg-laying chicken. Suppose you have a chicken and it lays eggs every once in a while. It is akin to how an ideal dividend paying company operate, in that the corporation makes money and then distributes the excess to their shareholders. The eggs are like dividends in that they are worth money.
So should I seek out companies that pay out the most dividend per dollar invested?
Not exactly, a company that pays out most or all their cash will have less to grow the company.
A company that isn’t willing to reinvest or have no avenues to grow will be sidelined by market competition eventually.
A company that is sidelined by market competition may end up losing capital value, resulting in your shares being lower in value relative to purchase price.
Furthermore, If the company is selling core assets to pay their dividends, then the sales level and profitability of the company will be adversely affected.
This may result in short-term dividends paid out to shareholders, but a resulting weakening in competitive position.
No point making dividends and paying tax on the dividend income if you lose more capital than you make in dividends.
Got it, so seek out companies that do not pay dividends?
A company that do not pay dividends will reinvest the earnings into its operations to grow its share price. Your reward as an investor will then not be the dividends you receive, but the growth in capital value. While this makes sense on paper, there are higher risks involved in this strategy:
Projects can backfire and result in wasted cash
Those monies could of been dividends.
On the other hand:
There may be many lucrative projects available requiring cash.
These projects solidify the company’s position as a market leader.
This may result in share price appreciation.
The real answer is to seek out dividends that are sustainable.
A company with strong corporate finance will be able to ascertain how much excess cash should be sustainably paid out, reinvested or saved as defensive buffer.
Sustainable dividends are lucrative and I would diversify my holdings as a share investor.
I would like to emphasise that investing carries large amounts of risk and losing money is always a possibility. It is important to understand and recognise the limits of your knowledge and capital. Personally my recommendation to a non-investor reading this post would be not invest in the share market unless you really know what you are doing. People, smart and stupid, old and young have overextended and lost fortunes thinking they can make money quick.