Several decades ago, almost all shares paid dividends back to their investors.  That was the principal reason investors bought shares in the first place.  Indeed, during those days the prevailing philosophy in the investing capital of the world – Wall Street – was the purpose of a company is to pay dividends.

Obviously, a company could not pay dividends to its owners without first making a profit.  However, paying out a portion of the profits to shareholders is only one of three things a company can do with the money it has earned.  Companies can also reinvest profits into growing the business or buying back shares to increase shareholder value.

In those bygone days, “living off your dividends” was a common retirement goal of intelligent investors.  Perhaps as a reflection of more conservative times, the safety in dividends was preferable to higher returns through hefty increases in share price.

In the latter part of the twentieth century, all that changed as investors flocked to the altar of massive returns through price appreciation.  Investors no longer lusted after dividends.  Instead, they looked for companies to reinvest their profits and grow, grow, and grow again, all the while driving up the share price.

Although dividend-paying shares never went completely out of favor, some investors seeking more secure investments preferred to diversify their portfolios with bond market investments.  

Dividend paying shares are gaining in popularity these days and market volatility over the last decade may have something to do with it.  Considering the fact dividend payers have performed better over time than other investments with less volatility, it is somewhat surprising they lost some of their luster in the not too distant past.

Here are a few things you need to know about the mechanics of dividend paying shares.

First, with the exception of a separate class of shares known as preference shares, dividends of ordinary or common shares are not paid automatically.  The company’s Board of Directors officially declares a dividend, payable to shareholders of record as of a given date as well as the date dividends are actually paid.  Here are the four dates you need to know:

1.    Declaration Date
2.    Ex-Dividend Date
3.    Date of Record
4.    Payout Date

Obviously no board will declare a dividend if the company is not in the financial position to pay it.  Some investors fail to consider this potential downside in dividend investing.  Most of the better Australian financial websites, however, can provide a company’s dividend history, which shows how consistently the company has declared dividends in the past.

The Date of Record acts as the cutoff point for shareholders entitled to receive the dividend.  However, due to the time it takes to settle a trade officially, the more important date is the Ex-Dividend date, which in Australia is 4 days prior to the Date of Record.  If you purchased the shares on or before the Ex-Dividend date, you will be a shareholder of record on the Date of Record and you get the cash on the Payment Date.  Some investors choose to have their dividend payments reinvested in more shares.

For some short-term investors, these dates offer attractive trading opportunities.  Typically, share price will drop on the Ex-Dividend date in the amount of the dividend to be paid.  However, share price of fundamentally sound companies will typically rise as the date approaches, as some investors buy in to get the dividend.  After the Ex-Dividend date, share price usually begins to appreciate back to the level seen on the Ex-Dividend Date.

There are advisory services that specialise in helping short-term investors trade this dividend period.  While it is possible to trade the period with shares, there are other ways to take advantage of the dividend period, including options and CFDs.  This kind of trading is not for newcomers to share market investing.  

Now that we have reviewed the basics of receiving dividends, it is time to look at some of the characteristics to look for in a quality dividend paying investment.  You can enter numerical values for most of these characteristics into a Stock Screener to produce a list of potential dividend paying shares.  Here are five you should know:

1.    Minimum Dividend Yield
2.    Market Capitalisation
3.    Sustainable Payout Ratio
4.    Profitability
5.    Institutional Ownership

Dividend Yield

Dividend Yield is expressed as a percentage, dividing dividends paid out in a 12-month period by the share price you paid.  The Dividend Yields you see listed on financial websites reflects prior year’s dividends at the current share price.  Some investors look for Dividend Yields as low as 3%, while others opt for yields as high as 15% or more.  

Market Capitalisation

Market Capitalisation reflects the size of the company – the number of shares outstanding in the market multiplied by the current share price.  As a rule, larger companies are more likely to make dividend payments even in tough market conditions.

Payout Ratio

The Payout Ratio is the percentage of the company’s net income paid out in dividends.  This is a critical number to consider.  If you see a share with a 100% Payout Ratio, that means they are paying every dime of net income in dividends.  Although in the short term this may be possible, no company can sustain that kind of Payout Ratio over time.  Simply put, you can expect lower dividends in future years.  Not all Stock Screeners include this variable but you can find this value in the Key Statistics or Key Measures section of most Australian financial websites.

Profitability

Many investors use Return on Equity (ROE) as a measure of profitability for dividend paying shares.  Since most dividend paying shares tend to be slow growth shares, a 10% ROE generates more potential shares in your Screener results.

Debt

The Debt to Equity Ratio is a measure of debt to shareholder equity, and the lower the number the better.  Most investors look to use a ratio around .5, since many dividend-paying shares are mature companies that typically carry some debt.

Institutional Ownership

This is another variable characteristic you will not find in a Screener.  However, it is a good indicator of the willingness of what some call the “smart money” to own the shares.

Intelligent investors do not select a dividend-paying share based on the dividend yield alone.  Remember, you are not buying bonds here.  You should consider the fundamental soundness of the company in addition to its yield and dividend history.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.