In the world of investing, dividends are an important factor investors cannot afford to overlook. A dividend is a portion of a company's earnings paid out to shareholders, typically on a regular schedule. It is a direct and tangible reward for investing in a company, a testament to its financial health and stability.
Dividends and Compounding
Perhaps one of the most captivating features of dividends is their ability to compound, which is the financial equivalent of a snowball rolling down a hill, gathering more snow, and becoming larger over time. In terms of investing, compounding refers to the process where an investment’s earnings are reinvested to earn additional earnings over time.
The power of compounding dividends is one of the magical elements of investing. It’s essentially earning income on your income, causing your wealth to grow exponentially over time. Let’s take a hypothetical scenario to illustrate this. Suppose you own 1,000 shares in Company A, which pays an annual dividend of $1 per share. Over a year, you receive $1,000 in dividends. Instead of spending this money, you decide to reinvest it by buying more shares in Company A. Assuming the share price remains constant at $10, your $1,000 dividend buys you an additional 100 shares. Next year, you’ll receive dividends not just on your original 1,000 shares, but also on the extra 100 shares you bought with your reinvested dividends. So, instead of receiving $1,000, you get $1,100. If you continue to reinvest these dividends year after year, your stock holdings in Company A and your annual dividend income will grow exponentially. This is the power of compounding dividends – earning dividends on your dividends, a process that can significantly enhance your wealth over time.
Franking Credits
Franking credits, also known as imputation credits, are a unique facet of the Australian tax system, designed to eliminate the double taxation of company profits. When a company pays dividends out of its after-tax profits, those dividends are said to be ‘franked’. The franking credits attached to the dividends are equivalent to the tax already paid by the company, currently at a corporate tax rate of 30%.
For an Australian investor, franking credits are a valuable tax break. If your marginal tax rate is lower than the company’s tax rate, you can claim a refund on the difference.
Let’s use a hypothetical example to illustrate this. Assume that you receive $700 in fully franked dividends from a company. The franking credit attached to this dividend is approximately $300 (representing the 30% company tax already paid). Thus, the grossed-up dividend, which is the total of the dividend plus the franking credit, equals $1,000.
If you, as an individual, have a marginal tax rate of 15%, your tax on the grossed-up dividend would be $150 ($1,000 x 15%). But remember, the company has already paid $300 in tax, which you receive as a franking credit. So, you can offset this credit against your tax liability, meaning not only do you have no further tax to pay, but you’re also entitled to a tax refund of $150 ($300 franking credit – $150 tax on dividend).
This ability to claim a refund of excess franking credits makes investing in companies that pay fully franked dividends a very attractive strategy for Australian investors on lower tax rates. It can significantly enhance the after-tax return on their investment, thereby promoting wealth creation. Investors should be mindful of the 45-day holding rule relating to franking credits, more information can be found here.
High Dividend Yielding Shares During High-Interest Rates
In times of high or rising interest rates and inflation, like the current environment, the investment world can seem turbulent. It’s an economic condition that often causes ripples across markets and impacts various investment types differently. Yet, astute investors often find a silver lining in high dividend-yielding shares.
High-interest rates usually signal a robust, growing economy. Companies that are financially strong and well-positioned within their markets have the potential to maintain, and in some cases even increase, their dividend payments during these periods. Often, these businesses operate in sectors such as utilities, financials, or consumer staples – sectors that can generate stable revenues and profits regardless of the broader economic climate.
Such companies can pay out higher dividends relative to their share price, meaning they have a high dividend yield, or the percentage the dividend represents compared to the share price. These dividends can be particularly attractive during periods of high-interest rates for several reasons.
Reliable Income Stream: Provide investors with a regular income that can be attractive compared to bonds and savings accounts. This regular cash flow can be particularly valuable when other investments might be underperforming due to rising interest rates and helps to avoid selling assets to generate income, which can be less tax efficient.
Cushion against Capital Losses: High yields can offer a level of protection in volatile market conditions. Even if a company’s share price falls, the dividend payment can compensate for that loss, at least to an extent. This buffering capacity makes these shares a safer haven during high-interest rate scenarios. Additionally, stocks with a high dividend yield generally have lower valuations than their growth peers, meaning they are less exposed to interest rates and lower valuations provide a buffer during periods of market stress.
Reinvestment Opportunities: Dividends can provide more opportunities for reinvestment, thereby further fuelling the power of compounding. By reinvesting dividends, you can continue to grow your shareholding in a company, even when the broader market is facing headwinds from rising interest rates.
Inflation Hedge: In periods of high interest rates, inflation often follows suit. High-dividend stocks can provide an effective hedge against inflation. Dividends can grow over time, thereby helping to maintain the purchasing power of the investor’s income.
Dividends play a crucial role in investing. Their ability to provide a regular income stream, be reinvested for compounding growth, offset tax liabilities, and prove resilient in high-interest scenarios make them a vital instrument in a well-diversified portfolio. Dividends and the strategies around them can serve as important signposts on this journey.
