What are dividends and why do they matter

In plain terms, a dividend is a portion of a company's profits paid out to shareholders. Sounds simple, but to new investors, dividends can seem like a mystery: Why did I just get paid for holding this stock? Is it free money? Should I only buy dividend stocks? In this beginner-friendly guide, we're going to break down dividends - what dividends are, how they work, and why they matter.

1. What exactly is a dividend?

A dividend is essentially your share of a company's profits. When a company makes money and doesn't reinvest all of it back into the business, it might distribute some to shareholders as a reward. It's usually quoted as an amount per share e.g., a 50 cent dividend per share means if you own 100 shares, you get $50. Companies typically pay dividends on a schedule - often every six months in Australia (interim and final dividend) or quarterly for many US companies. Think of it like this: if owning a stock is like owning a tiny piece of a business, a dividend is your slice of the pie when the business does well.

Dividends are usually paid in cash, straight into your brokerage account. Some companies also offer Dividend Reinvestment Plans (DRPs) where you can choose to reinvest that cash into more shares automatically, often with no brokerage fee and sometimes at a slight discount. That's an optional thing, but a popular way to compound wealth over time (more on that later).

It's important to note not all companies pay dividends. Younger, fast-growing companies (say a hot tech startup) often reinvest all profits to fuel growth, instead of paying shareholders. On the other hand, big established firms that generate stable profits often pay regular dividends because they might not have better uses for all their cash.

In short: Dividend = periodic profit payout. It's the company's way of saying "thanks for investing in us." But it's not exactly free money – it's coming out of the company's earnings. Still, dividends can provide a nice income stream or a way to buy more shares without adding new money.

2. Why companies pay (or don't pay) dividends

So why do some companies dish out dividends while others don't? It boils down to a company's strategy and life stage:

Growth companies (no or low dividends): Imagine a young tech firm that's doubling its revenue every year. It needs every dollar to hire talent, invest in R&D, and expand. Such a company likely won't pay dividends because it believes reinvesting the money will increase the company's value (and stock price) more. Shareholders benefit through capital growth instead. A real-world example is Amazon who hasn't paid a dividend for decades (and still doesn't) because it relentlessly plowed money back into growth. Many small-cap stocks on the ASX are the same.

Mature companies (high dividends): Now think of a big four Australian bank or a utility company. They have a steady, somewhat saturated business with limited high-growth opportunities. These companies often generate more cash than they can effectively reinvest. What to do with the excess? Return it to shareholders. That's why Australian banks and miners are known for generous dividends. For instance, in good years mining giants like BHP or Rio Tinto throw off massive cash and pay it out (BHP had periods of 6-7%+ dividend yields).

Signaling confidence: Sometimes a company initiates or raises a dividend to show that it's confident in its future earnings. Consistently growing dividends can attract a certain class of investors (income-focused, retirees, etc.), potentially supporting the stock price. Conversely, cutting a dividend is seen as a bad sign. It may indicate the company is in trouble or profits are falling.

There's no requirement to ever pay a dividend and it's totally up to the company's board. Some extremely successful companies never paid dividends but delivered value via share price growth (e.g., Google or Tesla historically). Others made investors wealthy largely because of their steady dividends plus growth (these are called "dividend aristocrats" - a term for companies that increased dividends annually for 25+ years).

3. Show me the money! (Why are dividends important for investors?)

Why should you care about dividends as an investor? Because they can significantly boost your total investment return. Total return = price gain + dividends received. Over the long run, dividends have been a huge component of stock market returns, especially in markets like Australia.

Historically, dividends (and their reinvestment) have accounted for about half of the total returns of Australian shares.​ Yes, half! For example, if the stock market delivered ~10% annual return on average, roughly 5% came from price growth and ~5% from dividends. In fact, Australia has one of the highest dividend yields among developed markets - its around 3.5-4% trailing yield on the ASX 300 index​, which is higher than the US or Europe on average. This means investors here often get more cash income from their shares.

Now, the magic happens when you reinvest those dividends. Instead of pocketing the cash to spend, imagine you use it to buy more shares. Then those new shares themselves start earning dividends, which buy more shares, and so on. This compounding can lead to substantial growth over time.

Dividends also provide a downside cushion. In a flat or down market, getting a 4-5% dividend yield means you still earned some return that year. For example, during some volatile years, the ASX's dividend yield actually was the main source of return while prices fluctuated.

4. The Aussie advantage of dividend yield and franking

You'll often hear about a stock's dividend yield. This is just the annual dividends per share divided by the share price, expressed as a percentage. It's like an interest rate on your stock. For example, if a stock is $20 and it paid $1 in dividends over the past year, the yield is 5%.

Australia often boasts relatively high yields. As of late 2024, the ASX 200 average yield was around 4%​, compared to the S&P 500 in the US around 1.5-2%. Some individual stocks have yields of 6-7% or more. For instance, big banks like Westpac or CBA have had yields in that ballpark at times, and Telstra traditionally had high payouts.

Now, the uniquely Australian goodie: franking credits. Australia has a dividend imputation system where companies paying dividends attach credits for the tax they've already paid on profits. For example, Australian companies pay a 30% corporate tax. If they pay a $0.70 dividend after tax from $1 of earnings, they'll attach a $0.30 franking credit. As a shareholder, you get the $0.70 in cash and a $0.30 credit. Come tax time, that credit can offset your own tax. If you're on a low tax bracket, you might even get a refund. If you're on a high bracket, it prevents double taxation (you effectively only pay the difference between your tax rate and 30%). For retirees with low taxable income, franking credits are like a bonus - they often get the full credit back. This makes dividends extremely tax-efficient in Australia.

In practical terms, a "fully franked" dividend of 4% yield actually has a grossed-up yield of around 5.7%​ for someone who can use the credits fully. That's a significant boost! It's why Aussie investors love franked dividends - you're not just getting the cash, you're getting credit for tax already paid.

Bottom line: Always consider the dividend yield + franking when comparing investments in Australia.