How Dividend Stocks Work
Whether we’re talking about the stock market or private corporations, dividends are ways for corporations to distribute profits to the company’s shareholders and unit holders.
If I own a plumbing business that’s profitable, incorporated and we want to distribute the profit to perhaps myself as well as my business partner, we could distribute through a dividend.
Typically, you’ll pay yourself a salary. You might also pay yourself a dividend, and the dividends are traditionally Canadian eligible dividends which can be highly tax efficient.
With respect to publicly traded companies who have large balance sheets, you’re able to buy and sell them on an exchange and they will generally declare what their dividend policy is for the year.
It’s typically quarterly distributions for the unit holders with the opportunity at some point down the line to increase that dividend. Now, the dividend is NOT guaranteed. Contrary to what most people think.
If you have a bank stock, an insurance company or a telecom company that the dividend is effectively “guaranteed”, just know that it is NOT 100% guaranteed. They can cut the dividends and they can cut distributions.
Although, most large Canadian companies tend to do anything else before cutting their distribution. They’re going to look at their balance sheets. They’ll look to see if they can sell assets before cutting their distributions and cutting a dividend. I’d say it’s extremely rare as it doesn’t happen that often.
How does the actual dividend work?
The board, CEO and/or management will decide exactly what they’re paying. Now if you want to know your dividend yield, it’s quite simple. You calculate your annual dividend, your trailing 12 dividend or even your quarterly dividend (multiply times four), divided by the current stock price, and that gives you your current dividend yield.
Annual Dividend / Current Stock Price = Current Dividend Yield.
That’s what you could expect to get over the next 12 months owning that stock.
Dividend Payout Ratio
Now, there’s also something called a dividend payout ratio. The dividend payout ratio is telling you how much of the profits that company is sharing with you as a stockholder.
Let’s do some simple math. If the company made $10 profit and they’re paying you $4, that would be a 40% dividend payout ratio. That number is important because you want to know how healthy the company’s balance sheet is.
The larger the payout ratio, the less safe the dividend would be. If they’re paying out more than the profits, that’s usually not a good sign. You want the payout ratio to be healthy. Most of the Canadian banks, financial institutions like to be in the 40% to 60% range. Generally, these are mature companies.
Who pays a dividend and why do they pay dividends?
In most cases, if you own a stock, that’s a growth play. In other words, we want that company to continue to generate double digit growth, compound annual growth on their balance sheet, on their profit and on their sales.
If you want the growth play, generally those companies will not be distributing a dividend.
What an investor might say in this case is that he or she would rather have the management team of the company keep the dividend, spend it on the company and get a better ROI opposed to having the investor do it on their own balance sheet or portfolio.
Growth stocks typically will not have a dividend. If they do have a dividend, it’s usually a small percentage that is being distributed like 1 or 2%. The mature companies, specifically in Canada, are in some of the following sectors: financials, real estate, infrastructure, utilities. They’re the ones who are paying dividends and have been paying dividends for a while.
For Growth companies, we want them to spend the money and make it on their own.
Dividends are typically paid out quarterly. Most companies will pay out their dividend quarterly. The distribution gets announced, then it gets paid usually anywhere from 10 to 20 days after the end of the prior quarter and it usually gets paid directly to your investment account.
Now, there are some old school investors out there who continue to own a certificate. If you have a certificate of a thousand shares of Manulife Financial for example, you might be receiving an actual physical check to your home address every quarter, which has the dividends on it. Ideally, you’d like to set up automation process for that dividend. It would be best to have the dividend deposited electronically into an account and re-invest it.
Many firms will allow you to do a dividend reinvestment plan. What that means is they’ll take your dividend and re-invest it automatically if you don’t need the cash. If you’re an investor that doesn’t need the cashflow for that specific month or that specific quarter, you could reinvest it in the company.
Some companies will allow you to rebuy the shares of their own company at a discount to market. Perhaps it’s 2, 3 or maybe even 4% of the dividend reinvestment plan at a discount. This makes sense for many people because you’re buying the value of the shares at a discount to what would be the prevailing rate in the market. It’s an opportunity for you to make a few extra percentage points on your return with your dividend.
Next thing you know you’ve “dripped” as we like to call it (having your dividends re-invested). You’ve dripped all these shares and now you have way more shares working for you down the road.
Dividends are extremely tax efficient and more specifically, Canadian eligible dividends are extremely tax efficient.
If you’re a conservative investor, you might want to focus on more mature companies. They are especially efficient in non-registered accounts or corporate accounts because of the tax efficiency of the dividend. Dividend yield is ultra tax efficient.
You want to make sure you’re aware what your dividend payout ratio is for these mature companies or you can simply let your advisor worry about that 😉