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Why Dividends Matter

Investor interest in high yielding shares has been the “flavour of the month” for the past few years as interest returns on cash have stayed at many decade lows.

The major banks, Telstra, Wesfarmers and real estate investment trusts (the new name for listed property trusts) have been sought after as investors seek high yielding dividend paying stocks at the expense of their Cash investments which are stuck in a low yield world.

Dividend returns are an important part of investing in shares as they will provide a large and recurring portion of an investors future returns.  

In fact many yield focused investors solely buy shares for the fully franked dividends they provide and in comparison to the current low Cash Rate those dividends are prized attributes as they are more tax effective than pure interest and can (and do) grow over time ensuring inflation protection for the investor.

Companies that pay dividends should be a priority for your portfolio for this tax effective income return but also for the discipline dividend payments instil on a companies board. 

A company that elects to pay a certain percentage of its profits out as dividends to shareholders (the payout ratio) and strives to maintain and grow company profits is a company that is disciplined in its approach to the interest of share holders.

The board must run the company to ensure the profits of the company are predictable to provide the necessary profits for the desired dividend payout as well as retaining earnings to continue to grow the company  

This produces a “virtuous cycle” where the retained earnings are invested in additional growth opportunities with in the scope of the companies operations producing higher profits which thus lead to higher dividends for share holders over time.

With out this discipline of paying out a certain portion of earnings as dividends the company may well stray into less productive activities as a way of maximizing profitability.

The inbuilt “incentive” of dividend imputation with-in the Australian tax system leads local companies to reward shareholders with higher dividend payouts than their offshore colleagues.  

Capital Gains are (for the most part) taxed more leniently in offshore countries than in Australia whilst dividends are (usually) fully taxable to shareholders and this can mean that offshore companies tend to reward share holders via attempting to increase the share prices rather than via dividend payouts 

Many company boards will likewise consider they are a better investors of retained earnings and can achieve a higher return than share holders could if the profits were returned as dividends than as retained earnings   

This may or may not be true depending on the individual company concerned but a reasonable payout ratio and a high Return on Equity for the retained earnings (all things being equal) will allow share holders to enjoy a lower risk total return from there investment over time.

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