What's so great about dividends?
Updated: Feb 7
Dividend investing gets a lot of love. There are websites dedicated to it, many investing gurus swear by it, and dividend mutual funds are hugely popular. What’s all the fuss? What’s so great about dividends?
Dividends are a way to generate income from your investments and they can add a little stability to your portfolio. What exactly is a dividend? A dividend is a payment a company makes to its shareholders. Companies that are earning profits and generating cash have to do something with that money. After investing in their business, sometimes they have cash left over, and pay it out to shareholders. This is generally good for their stock price since many people love being paid dividends.
Here are three great qualities of dividends:
1. Some dividend-paying stocks will get you more income than a GIC or bond.
2. Dividends can grow every year, sometimes faster than inflation.
3. They are taxed at a lower rate than interest income.
A little more detail on each of these qualities
First, the dividend yield you can get on some stocks is higher than the rate of interest paid on a GIC. For example, TD Bank has a dividend yield of 3.8% (as of May 2, 2022), while a one-year GIC rate is about 2.5%. This means you are getting more income per dollar you invest buy owning TD Bank stock.
There are other stocks with even higher yields like BCE (5.3%), Manulife (4.8%) and Bank of Nova Scotia (4.6%). Investing your money in a bunch of these stocks can generate some nice income. Or, you can invest in an ETF that focuses on high dividend-paying companies. As an example, the Vanguard FTSE Canadian High Dividend Yield Index ETF has a yield of 3.4%.
Second, many companies not only pay a dividend every year, but also grow the dividend. In some cases, the dividend grows faster than inflation. For example, TD Bank has grown its dividend at an average rate of 11% per year since 1995. This means that in some years it grew faster than 11%, and in some years growth was slower, but the average growth rate was 11%. Income from TD’s stock has exceeded inflation by a long shot. Not all companies grow their dividends, though, and some reduce it or eliminate it. More on this below.
Third, dividends are taxed more favourably than interest income. When you earn interest, you pay income tax on the money just like regular employment income. Dividends, though, are taxed at a lower rate due to a mildly complicated calculation called the dividend tax credit. This makes dividends more attractive than interest payments.
This matters when your dividend-paying stocks or ETFs are held in a regular, non-registered account. Realize, though, that it doesn’t matter if you hold your dividend stocks in an RRSP because all income earned in an RRSP (and RESP) is taxed the same way, whether it’s interest income or dividend income. It also doesn’t matter in a TFSA because you aren’t taxed on any income you earn in that account.
DRIPs make a dividend even better
There are two ways you can be paid your dividend – in cash or in stock. If you choose to get it in cash, you’ll see the money show up in your investment account, usually every three months since dividends are usually paid on a quarterly basis. Many companies also offer another option: instead of paying you in cash, they will pay you in additional shares. This is called a dividend re-investment program (DRIP). A DRIP is great because you get more shares without having to pay a commission to buy them. It’s also a nice way to add discipline to your investing: instead of letting your cash sit in your account because you haven’t re-invested it, it is automatically re-invested in the market. Of course, a DRIP only works if you don’t need the cash to fund your expenses. Another bonus is that some companies will give you the additional shares at a discount to the market price, meaning the share they give you are cheaper than what you’d be able to buy in the market.
So why wouldn’t everyone just invest in high dividend-paying stocks?
If income from dividends is such a win, why would anyone choose a stock that doesn’t pay a dividend? Let’s go back to the point about why companies pay dividends. If a company has extra cash after investing in the growth of its business, it might pay that out to shareholders. But companies that are still growing quickly need every dollar of cash they can get to invest in their growth so there’s nothing left over for shareholders. This can be a very good thing if the company is investing wisely and is growing its earnings as a result of smart choices. Fast-growing companies can see their stock prices rise a lot faster than the slower-growth companies. Think Aritzia versus Rogers. Aritzia is expanding into the huge US market so its opportunity to grow earnings is good. Rogers is a well-established telecom company with fewer avenues for growth. Aritzia does not pay a dividend while Rogers is a long-standing dividend grower.
Dividends are not guaranteed
It’s important to realize that whether a company pays a dividend is completely up to them. Even if they say they plan to pay a dividend, they can retract that decision. A company might reduce or eliminate its dividend if they are short on cash, whether that’s because they need the money to make a big acquisition or business is bad. And when a company cuts the dividend, it’s usually bad news for the stock price. Note that a declining stock market isn’t usually a reason for a company to stop paying a dividend, so you might be able to reduce the downside in your portfolio in a weak market by owning dividend-paying stocks.
How do I get a piece of the dividend action?
You can buy dividend-paying stocks individually or you can invest in funds that focus on generating dividend income. Some mutual funds and ETFs aim to generate a higher dividend yield than the overall market – they are easy to identify since their names include the word “dividend.” Funds are alternatives to owning the individual stocks and have the benefit of being diversified (owning a lot of different companies).
You don’t have to invest in a dividend-focussed fund to receive dividends, though. Even funds that aren’t focussed on dividends will still receive them. For example, if you own an ETF that mirrors the Canadian market, that fund will certainly own companies that pay dividends – those dividends just won’t be as high as a dividend-focussed fund. For example, the iShares S&P/TSX Capped Composite Index ETF has a yield of 2.6%, whereas the equivalent fund that focuses on higher dividend companies has a yield of 3.6%.
You don’t necessarily need to go out of your way to invest in dividend-paying stocks – they aren’t necessarily “better” investments. They do, however, serve the purpose of generating income which might suit your needs.
What’s a dividend yield?
A dividend yield tells you how much income a stock pays in the form of a dividend, in percentage terms. This allows you to compare the income you get from a bond or GIC to a dividend-paying stock.
If you look on your bank’s website and see they are offering a GIC at a rate of 2.5%, this means they will pay you 2.5% of the value of what you invested. The simple calculation is:
amount you invest x interest rate = interest paid
$5,000 x 2.5% = $125
The yield in this case (called the interest rate) is 2.5%, calculated as $125/$5,000 = 2.5%.
It’s the same with a dividend yield, except the dividend payment replace the interest.
dividend per share / share price = dividend yield
$3.56 / $72.95 = 4.8%.