Over a year ago I wrote a blog post about the shocking investment truth no one told you about. In that example it shows not only the power of compound interest, but it also shows how powerful dividends can be when they are re-invested. This and the predictability of income make dividends extremely important when investing.
Investors focus predominantly on share price more so than anything when considering stocks. In fact, most investors don’t even care whether a stock pays a dividend or not and this is a critical mistake. Most common investors obsess over price appreciation and keep chasing after gains. They are gambling. Common stock buyers don’t understand the fundamentals of investing and attribute their actions as investing. They are not investing, but mere speculators.
Dividends Reward Investors
When it comes to investing, I like to use Robert Kiosaki’s definition from Rich Dad Poor Dad of what an investment truly is. It pays you to own it. That’s exactly what a dividend is. A dividend is a regular payment from a corporation to the shareholders of the company out of the profits. This is very important to remember.
By definition a dividend is a regular payment. This means a company should perpetually reward its shareholders for investing in the company. Dividends should happen regularly. Payments should happen on a monthly or quarterly (3 months) basis. Think of a dividend like an interest payment for depositing money in the bank. The reason why people save money in their bank account is to receive some form of interest payment. In corollary, this is the equivalent of what dividend accomplishes. It rewards the investor for putting money into the company.
Dividends Are Not Guaranteed
A corporation does not guarantee to pay a dividend. There are many stocks that an investor can buy that does not pay a dividend at all. Popular companies like Tesla and Amazon do not pay a shareholder to own the company. In fact, these companies make very little profit so paying the shareholder is all but impossible. Shareholders that own these stocks are merely speculating that the price of the company will go up. By the definition given by Robert Kiosaki, these stocks are not investments. They are speculative stocks that people use to gamble on the stock market.
Additionally, dividends are not guaranteed even if the company is paying them. That’s because it relies on profits to be available to pay out to the shareholder. If the company does not make a profit during a bad year, it’s possible that the dividend may get cut. In general, a corporation tries its best to fulfill the best interests of its shareholders, but there are times where even that is not possible.
How Safe Is A Dividend?
Many investors chase after dividends simply because it provides good income. This might be true, but not all dividend paying companies are created equal. Dividends are important because that’s what defines a stock for being an investment, but some companies could have dividends that are unsustainable.
Remember where I mention that dividends are monies given from profit that a company generates. Well, if a company struggles to generate any profit, how long do you think the dividend will last? Companies could also be paying a dividend to attractive investors, but they could be paying more than they actually make. How long will it take before the dividend gets cut? These are all very important things to look for when investing.
It’s not as simple as picking the highest dividend paying stock. This could lead to a disaster. In fact, when a dividend gets cut, investors usually sell the stock leading to large losses. This is something you need to be aware of. Don’t go investing blindly.
The Dividend Payout Ratio
This is why the dividend payout ratio is so important.
The dividend payout ratio tells us how sustainable the dividend is. A company that is paying out near 90% of it’s profit might be cause for concern because the dividend could get cut. The only companies that have such a high payout are income trusts like REITs. By definition, income trusts share all their profits with investors. Regular corporations do not exhibit this same behaviour.
Finding the dividend payout ratio for a specific corporation is very easy to do. Finance sites like Yahoo Finance provides statistics on dividends and the payout ratio is conveniently one of them.
The example above shows the payout ratio of a very successful technology company, Microsoft. This mature company pays a dividend of 1.25% which represents 34.72% of its profit. With that ratio the dividend looks fairly sustainable.
A good general rule of thumb to follow is this:
- Stock paying between 0 – 35% are generally companies that are growing and using their profits to grow even larger. If a company pays a dividend, they are paying very little back to the investor.
- Stocks paying anywhere from 35 – 50% are quite sustainable and providing a substantial amount back the investor.
- If the stock pays something over 50%, unless it’s a REIT, such a high dividend could be unsustainable or the company might not be growing very much intrinsically anymore
- A stock with a ratio over 100% means that the dividend is quite unsustainable and could see a future reduction or elimination. A company paying out more than it makes is never a good sign.
Dividends Receive Favourable Tax Breaks
Everyone hates taxes, but at the end of the day we have to pay them. I’m not an advocate of avoiding to pay taxes either. That’s because taxes help out the economy in other ways like providing healthcare, improving infrastructure and creating jobs in under appreciated industries. Unfortunately, all of us can’t be tech geniuses, lawyers and doctors.
Thankfully, when it comes to dividend income, the CRA gives a break on our taxes. Why does this happen? For starters dividend income comes from the profit of corporations. The profit is what remains in a corporation after all expenses, including income taxes are paid. If the government taxes dividends at the same rate as personal income, then they would effectively be taxing the dividends twice. Once at the corporate level and a second time at the individual level. This is the reason why dividend income receives a credit from the CRA. Essentially it’s like a rebate for the taxes that are already paid.
The Dividend Tax Credit
In order to understand just how much tax we pay on our dividends we first need to understand how the dividend tax credit works. When Canadian investors buy stock, the CRA provides a different credit depending if the stock is Canadian or international. Dividends from Canadian companies are given extra preferential treatment. Yes, the CRA wants us to invest in Canada.
To figure this out, let’s create an example. Let’s assume an investor collects a dividend of $100 from a Canadian company. The same investor also collects $100 from a US company. With all dollar values being Canadian let’s do some math.
For the Canadian dividends, an additional 38% is added to the dividend to “gross-up” the amount for taxation purposes. This means when an investor receives $100 in dividend, the amount to declare on a tax return must be $138. If this individual has a marginal tax rate of 33.89% in Ontario then the taxes owing is $46.77.
But wait! The Federal government provides a 15.0198% credit for dividend income. This credit will amount to $20.73 from the original $138 in gross up income. Effectively the tax owing is only $26.04 ($46.77 – $20.73). Being in Ontario another provincial credit of 10% would also apply to further reduce the tax bill. In the end an Ontario resident with a marginal tax rate of 33.89% would only pay 12.24% on dividend income. That’s a far cry from the 33.89% one pays for regular income. To find your dividend tax rate, Taxtips provides a table for all provinces.
Dividends outside of Canada do not receive as large a “gross-up” when calculating the credit. The tax credit is also much smaller for foreign income. Therefore, the amount of taxes to pay for ineligible dividends, or money made outside of Canada, is higher.
In the above example, an additional 15% is added to the dividend to “gross-up” the amount to $115. The marginal tax would amount to $38.94 for that amount. The credit on this dividend is only 9.0301% at the Federal level and for Ontario it recently go reduced to only 2.9863%. After applying all the credits the final tax bill on the $100 in dividends would equate to 25.16% or $25.16. This is still much better than paying the 33.89% marginal tax, but not as good as collecting Canadian dividends.
Overall the taxes on dividend income is much better than any type of income that one can earn in Canada. In fact, there are some tax brackets where dividend income can actually provide you with a tax credit on other earned income. Those in lower brackets can actually reduce their taxes by earning dividend income!
It’s Not Just About Fees, Dividends Are Important Too
Over the last decade so much has been made about keeping costs low when investing. This message keeps getting drilled into our heads over and over again by many discount brokerages offering low cost solutions. One of the most visible ads are at the ones that Questrade generates.
Keep the fees low. Stop buying expensive mutual funds. Do those all sound very familiar? That’s because marketing has the power to tell you low fees are good. Well, what if I say dividends are just as important to investing as low fees.
In my arbitrary example, the average growth of a $10,000 investment over 15 years is 4.93%. If an investor uses a high cost mutual fund with no dividend, the investment would become only $13,695.91. That’s a cumulative return of 36.96% over 15 years. Still better than a GIC, but we all know that high fees eat into our investment return.
Now with a low cost ETF saving 2% of the high cost mutual fund, the gains are more substantial. After 15 years the $10,000 will become $18,572.40. That’s a cumulative return of 85.72% return. We can see how a low cost fund can outperform a high cost one by a significant margin. That’s what companies like Questrade and Wealthsimple are marketing to. Go low cost and make a fortune.
So what happens if we ensure our low cost funds have a 2% dividend payout as well on top of the low fees. Well a $10,000 investment would turn into $22,638.35. After 15 years that’s a cumulative gain of 126.4%. That’s a full 40% more than investing without dividends and almost 100% more than investing in a low cost mutual fund with no dividends. See how powerful dividends can be? But wait there’s more!
Re-Invest Your Dividends
I hate to give up my secrets to investing, but this website is about learning how to become financially independent. I’ve already written about the one investment that your mom never told you about, so it shouldn’t come as a surprise on how one can really build up wealth. It’s not buying, Netflix or Amazon, but in fact it’s just all about re-investing your dividends.
Almost every single index fund allows for the re-investment of dividends. This is often called the Dividend Re-investment Plan, or DRIP for short. Many brokerages allow you to activate it and this is the secret weapon to building wealth.
My previous example provides the stark contrast between investing with a dividend and without. In this example, the chart shows the difference between extracting the divided out and re-investing it every single year. The results are amazing!
An investor that re-invests a 2% dividend over 15 years will end up with $26,605.60 whereas someone that collects the dividend and does nothing with it ends up with $22,638.35. The difference between the two is 17.5%. Using just $10,000 and never adding any more money, an investor would gain over 166% in return over 15 years. This is only with a portfolio that averages 4.93% over a decade and a half. How is your GIC looking now?
Index Funds Provide Dividends
Most people wonder where can I find a low cost fund that provides a stable 2% dividend and also can provide 4-5% in average growth a year. Well the answer is simple. A very generic, low cost index fund like the S&P 500 or the S&P TSX can provide just that.
I am always a fan of the Canadian Couch Potato index funds and for the beginners out there the TD e-Series makes a great way to start investing. Each of the index funds in the balanced portfolio provides a 2% dividend. The funds exhibit good long term growth potential with low fees to own and buy. There’s no better template to start with.
Become Financially Independent
The goal of this blog has always been to teach people to become financially independent. Using dividends as a source of passive income is definitely one way to achieve that. Though a small 2% dividend may seem small, what it does do is help build wealth. The example above shows just that. Even the slightest of dividends can make a big difference, especially when the dividend is reinvested.
To achieve financial independence, on needs to build a large enough nest egg such that a balanced investment portfolio is able to sustain the 4% withdrawal rate. Many financial planners consider the 4% withdrawal rate as the benchmark for a perpetually sustainable investment portfolio in retirement. A 2% dividend may seem small, but it already achieves half the requirement of the 4% withdrawal. This is our goal, to build wealth such that a mere 4% is enough to achieve our standard of living.
So the next time you invest, think not only about the fees that you are paying, but pay attention to what type of dividend you are getting. Remember that dividends come from profits and that’s why corporations are working for you. They are working to pay your dividend. Most importantly of all, they are working to help you achieve financial independence.