One of the first things I’d encourage new dividend investors to understand is that dividends aren’t free money. When a company pays a dividend, it’s transferring cash from its balance sheet to shareholders. On the ex-dividend date, its share price theoretically adjusts downward by the amount of the dividend, all else being equal.
Dividends are simply one way businesses return capital to shareholders. Companies can also repurchase their own shares or reinvest earnings into operations, acquisitions, and expansion. When management has limited opportunities to reinvest capital at attractive returns, paying a dividend can make sense.
As an investor, you have two broad choices. You can reinvest dividends to purchase additional shares and compound your total return or withdraw the cash to supplement your income. Both approaches are reasonable, but before pursuing either, I’d make sure you understand how dividend yields work, what makes a payout sustainable, and how dividends are taxed.
Source: Getty Images
How the dividend yield is calculated
Dividend yield measures a company’s annual dividend payments relative to its current share price. For example, suppose a stock trades at $50 and pays $2 in annual dividends. Its dividend yield is 4%. However, you’ll encounter two ways of calculating that figure.
The trailing 12-month yield divides the dividends actually paid over the previous year by the current share price. The forward annualized yield takes the most recently declared monthly or quarterly regular dividend, assumes that payment continues at the same frequency for a full year, and divides the result by the current share price.
These figures can differ if a company recently increased or reduced its dividend. Also remember that a rising yield isn’t necessarily good news. If a stock’s price falls while its dividend remains unchanged, the yield increases even though the business may be deteriorating.
Look beyond yield to dividend quality
Personally, I’d rather own a company paying a sustainable 2% dividend than one offering an 8% yield that’s likely to be cut. One of the first metrics I’d examine is the payout ratio, which compares dividends with the earnings or cash flow available to fund them.
For a conventional corporation, you can divide annual dividends per share by earnings per share (EPS). Alternatively, comparing total dividends paid with free cash flow can be useful for depreciation-heavy utility and real estate stocks.
Neither metric is perfect. Earnings can fluctuate, while free cash flow may temporarily decline because of major investments. Therefore, I’d also examine how many consecutive years the company has increased its dividend and the annualized rate of that growth.
A long record of increases suggests management prioritizes shareholder distributions, while dividend growth that consistently exceeds inflation can help preserve purchasing power. Still, historical dividend growth isn’t a guarantee of future payments.
Understand how dividends are taxed
Inside a Tax-Free Savings Account (TFSA), dividends are received tax-free. In a Registered Retirement Savings Plan (RRSP), investment income grows tax-deferred, although withdrawals are generally taxable.
Outside registered accounts, dividends are generally divided into eligible and non-eligible categories. Both categories are subject to different gross-up and dividend tax credit calculations, with the actual tax burden depending on your income and province of residence.
Consider a dividend ETF instead of picking stocks
If you don’t want to research individual companies, I’d consider outsourcing the process to a diversified dividend exchange-traded fund (ETF). One option is the Vanguard FTSE Canadian High Dividend Yield Index ETF (TSX: VDY).
VDY tracks an index of Canadian stocks with above-average dividend yields, providing exposure to established dividend-paying businesses across sectors such as financials, energy, and telecommunications. It charges a 0.22% expense ratio and offers a 3.1% trailing 12-month distribution yield, with payments made monthly.
Because the portfolio primarily holds Canadian dividend-paying corporations, much of its distributions generally consist of eligible Canadian dividends, although the actual tax character can vary from year to year.
The main drawback is concentration. Canada’s highest-yielding stocks are heavily represented in financials and energy, so VDY shouldn’t necessarily be your only equity investment.
