What are dividends and how do they fit into an investment portfolio?

Dividends are the payments a public company (a company whose shares trade on an exchange) makes to its owners (shareholders). Dividends are a way for companies to return some of their profits to the owners of the company. You may receive dividends directly if you directly own shares of a public company, or indirectly (in the form of distributions) if you own mutual funds, exchange-traded funds (ETFs), or other pooled vehicles that hold equities.

Each company determines how often it will pay dividends (if at all), which is explained in its dividend policy. Most companies pay dividends on a quarterly basis, but it’s not rare to see them paid semi-annually or annually instead. In addition to regularly schedule dividends, companies may also issue special, one-time dividend payments.

The Board of Directors of each company determines the company’s dividend policy.

What kinds of companies pay dividends?

Since it’s not a requirement, not all public companies pay dividends. Generally, very young companies don’t pay dividends, since they often prefer to use their profits to invest in their own growth. Companies are more likely to start paying dividends as they grow and become more profitable, but that’s not a concrete rule. There are many large, profitable companies that don’t pay dividends.

Dividend policies also tend to be very different between sectors. In Canada, companies in the energy and communication services sectors currently have the highest dividend yield at 5.24% and 5.01%, respectively, while information technology (0.25%) and industrials (1.22%) have the lowest.

Each company’s dividend policy is public information and can usually be found on its website, in its regulatory filings, or on any major financial publication’s website. Although you can easily find out how much a company pays per share, it’s also helpful to calculate its dividend yield (its dividend payments as a percentage of its stock price). The dividend yield tells you how much income you’ll get from the company for every dollar you invest in it (assuming its dividend policy doesn’t change, and the payments are made). It’s simply the annual dividends per share divided by the price per share.

How are dividends different from interest payments on bonds?

There are critical differences between the types of income you might receive from investing in a company. Dividends are paid only to owners (shareholders) of the company. On the other hand, interest payments are made to a company’s creditors—those who hold the company’s bonds. Also, as mentioned, dividends don’t have to be paid, but bond interest payments are contractual, and if they aren’t paid, the company could be in default.

Moreover, certain dividends are taxed differently from bond interest payments. Dividends from Canadian corporations have preferential tax treatment, as they’re subject to a dividend tax credit in the hands of the taxpayer. However, the same isn’t true of dividends paid by foreign corporations—they’re taxed as ordinary income. Interest payments from bonds are also taxed as ordinary income, making them less tax efficient than dividends from Canadian corporations.

What are the advantages of dividends? Why would investors buy a stock that pays dividends?

Dividends have been significant contributors to investors’ total returns (returns from both capital appreciation and dividends) over time, particularly in Canada where dividend-paying sectors like banks and energy companies make up a large part (about half) of the market. Over time, and particularly in thanks to the power of compounding (more on that below), dividends can be a major component of a portfolio’s returns. For example, over the last 20 years, $10,000 invested in the S&P/TSX Composite Index, without taking into account the dividend component of returns, would’ve grown to almost $30,400 by March 2023 (a compound annual growth rate of 5.64%). But taking into account re-invested dividends, it would’ve grown to over $53,000, for an annual growth rate of 8.60%.

Investors can also choose to reinvest dividend payments back into the market to take advantage of the power of compounding. When doing so, the dividends you receive are used to buy shares in the company, which would increase the amount you receive at the next dividend payment date, so you’d purchase even more shares, and so on. This can be simplified through automatic dividend reinvestment plans (DRIPs), which are offered by most brokerage firms. Reinvesting dividends also allows you to take advantage of dollar-cost averaging, which can help lower the amount of tax you might have to pay on any capital gains, thanks to a higher adjusted cost base.

Dividends can also be a reliable source of income in market downturns, weaker economies, and times of high inflation. Corporations are generally hesitant to lower or cancel their dividend, even in tough economic times. That’s because the market tends to punish companies that do so without a proper explanation and plan to get their dividends back on track, and it can take years for a company to earn back investors’ trust as a solid dividend payer. Dividends can also help fight inflation, since receiving cash dividends means you don’t necessarily have to sell any stock to generate cash. Moreover, in response to high inflation, some companies can actually increase the price they charge for their goods, which can help generate profits that may be returned to investors in the form of dividends.

Are dividend-paying companies a good investment?

With a demonstrated history of adding to total returns, their tax advantages, and their potential to provide income in difficult economic environments, dividend-paying companies can be a great addition to one’s portfolio. But not all dividend-paying companies are created equal, and some are more suitable for certain investor types than others, so security selection is paramount. Moreover, a company’s dividend policy is just one of the many elements to consider in evaluating the suitability of a stock for your portfolio. Like any investment, they should be considered as part of a wider portfolio construction strategy and should be part of a diversified portfolio.