By Colin MacAskill
Dividends are quarterly payouts from a company to its shareholders. And today's healthy dividend yields are eclipsing those of money market funds and the bond market. Their advantages are numerous and they carry great potential. But how powerful is the power of dividends?
Income-focused investors often look to dividend-paying stocks - typically large-cap companies that are less volatile - as a source of stability and income and as a way to diversify their portfolios. Although companies are not obligated to pay dividends to investors, most continue to do so. In fact, all of the largest Canadian banks are known to maintain their dividend payouts to investors instead of reinvesting them, and today the Big Five average yield is about 4.4% (Globe Investor).
Some investors see dividend payments as a signal of the company's confidence in its future earning power, particularly in tenuous markets. They also help to mitigate stock market downturns, particularly in the wake of the financial crisis.
The long-term advantages
According to Standard and Poor's, dividends have contributed to approximately one third of S&P 500 total return since 1926, while capital appreciations have contributed two thirds. Therefore, both sustainable dividend income and capital appreciation potential are important to total return expectations.
Closer to home, and more recently, dividends have contributed 2.5% of the average 7.5% total return of the S&P/TSX Composite Index (Jan. 31, 2009, Morningstar; annual compound total return for S&P/TSX Composite Index from 1988-2008). Today, because stock valuations are lower, the dividend yield (the dividend paid per share divided by the share price) on the S&P/TSX Composite Index is higher.
The DRIP strategy
Many stocks make automatic Dividend Reinvestment Plans (DRIPs) available, through which investors can reinvest their dividends for future growth (and more dividends) instead of spending them.
Suppose you invest $100 initially, and an additional $75 per quarter, at an anticipated stock price appreciation of 7% and an anticipated dividend yield of 2%. In 20 years, you would have invested a total of $6,025 and reinvested dividends of $2,324.88 for a total cost basis of $8,349.88. Your capital gain would be $8,166.42- and your total value would be $16,516.29!
Dividend tax advantages
Dividends received from Canadian corporations are effectively taxed at a lower rate than interest income, due to the dividend tax credit that is applied to the federal and provincial tax payable. This tax credit is meant to recognize that the Canadian corporation paying the dividends has already paid tax on its earnings, which are now being distributed to its investors. Dividends from foreign corporations do not receive the same dividend tax credit, and are taxed at a higher rate than those of Canadian corporations.
For example, if you earn more than $126,000 in annual taxable income, and receive $1,000 in dividend income from a Canadian company, you keep approximately $775 after federal and provincial taxes - less the dividend tax credit. By comparison, $1,000 in interest income will net about $555 after taxes - the same for $1,000 in foreign dividend income, because it is not subject to the tax credit for Canadian corporations, and is taxed at a higher rate.
When considered in light of total returns and tax advantages, dividend-paying stocks may be an attractive option.
This article is supplied by Colin MacAskil, a vice-president and, investment advisor with RBC Dominion Securities Inc. This article is for information purposes only. Please consult with a professional advisor before taking any action based on information in this article. Colin welcomes your calls on his direct line 604-257-7455.
