Do you understand the role that dividends play in the return of your portfolio? If not, then this blog is for you. Ignore the dividend effect at your peril. Learn about the five effects that strong dividends have on your investment strategy. Failing to account for dividend returns could result in sub-optimal returns.
Why are dividends valuable?
Dividends are valuable when it comes to investing, but only to the extent that they support growth. What is vital is your Total Return:
Total Return = Capital Growth + Dividends Paid
Capital growth means that the value of the company or companies that you have invested in increases over time. This is measured by either the company’s market capitalization or the net asset value.
Dividends are a return of profit paid to shareholders.
How much money you make over a number of years includes both growth and dividends. Some companies, including Amazon, Google, and Warren Buffet’s company, Berkshire Hathaway, have a zero Dividends Paid within the equation above. These companies prefer to reward shareholders with growth and they reinvest profits to improve and innovate.
If you want to make money, your total return needs to be above inflation. While the Dividends Paid can be at zero, the Capital Growth cannot be, or at least not for long.
There can be a tendency to get caught up in yield. You may be familiar with yield if you rent out a property. How much rental income does the property provide? The annual figure compared to the value of the property is your income yield. This can be calculated before any tax, costs, or charges (gross yield) or after all deductions (net yield).
This principle is the same for companies: the yield is the value of dividends received in a year compared to the value of the holding.
You should value yield as it can provide an income stream. This is even more relevant in today’s low-interest-rate environment. However, yield can be deceiving. If a company’s yield increases from 4% to 8%, is this the result of increased profit or is it because the share price fell by 50%?
Companies can borrow money to pay a dividend because they know that investors appreciate them. Borrowing to pay a dividend can be a warning flag. Therefore, the headline figure of a paid dividend is not as powerful as looking under the bonnet.
A better indicator of the strength of a company would be a consistent dividend rate. Is the dividend at least as much as it was last year? Is there good dividend cover (how many times can profit cover the dividend payment)? Are dividends paid every year?
Dividends can vary each year and companies typically pay dividends at different times, making it an inconsistent income stream. This is not a problem, but most people like to know how much they have coming in each month.
For this reason, it can make more sense to withdraw a known amount of capital each month.
There are five key reasons why dividends matter:
Albert Einstein said compound returns were the eighth wonder of the world, and with good reason. If you invested £100, with a 5% dividend provided each year, you would make £25 after withdrawing this each year for five years. However, if you had reinvested the 5% each year, then you would have made £27.63 (2.63% more).
After 10 years, the difference is even more. You would have made £62.89 compared to £50 (12.89% more). After 20 years, this increases further to 165.33% more. There is one simple reason for such rapidly increasing numbers: you’re making money from your returns. There is no other way your money can work as hard for you as reinvesting dividends and compound returns.
A profitable company is a healthy company. A company paying good dividends and maintaining them over many years is on your side. If they are profitable, you should be profitable.
Fledgling companies can’t afford to pay dividends. They may (or may not) be tomorrow’s success story. Today, they need to ensure survival by being innovative, increasing market share, and paying staff wages.
Companies paying good, reliable dividends are older companies with a proven track record. You are unlikely to experience considerable capital growth because that happened when they were yesteryear’s small companies. Nonetheless, their steady dividends can help provide security in an investment portfolio and can protect against the shocks of market downturns (as long as you are diversified).
4. Lower tax
The tax on dividends is not as high as the tax on your other income, including salary, rental income, and interest payments. Tax on these items is 20%, 40%, and 45%, depending on how much you earn overall.
Dividend tax starts at 7.5% and increases through 32.5% to 38.1%. You do get a tax-free personal allowance, but that starts to diminish once you earn over £100,000. The dividend allowance (currently £2,000) is available to all, no matter what your earnings are.
While the percentage figures may change over time, the general idea behind lower dividend rates remains. The Government wants the public to invest in companies to support capitalism and create companies that in turn provide employment, tax revenue, and success for the country.
Incentives for investing in dividend-paying companies can also improve the saving behaviour of the public, meaning less reliance on state intervention.
5. Shared success
Dividends matter to company owners as well as both big corporate investors and smaller individual investors. If a company continually pays good dividends, it shows that the company owners are invested in its success, which can be a confidence marker.
Dividends are important but you should not get so focused on them that you end up hurting your total return. You shouldn’t worry about finding a high dividend yield to support your income. As long as you have a good investment strategy, you will be able to support a good capital withdrawal strategy, knowing that any underlying dividends will be supporting this.
Investing can be tricky. If you want some help to create your own investment strategy, call one of the specialist team at Capital.