Most profitable companies pay a portion of their profits to shareholders each year as dividends. Dividends provide income in much the same way an interest rate security pays interest, however a major difference is that unlike interest, a dividend payment can be varied or withheld by a company if business conditions deteriorate.
In Australia, most established successful companies have tended to pay regular dividends which have increased as their profits have risen. In less profitable years, company directors may elect to utilise past earnings to maintain dividends at a relatively consistent level. With careful selection of dividend paying stocks, the risk of income volatility can be greatly reduced.
When using equities within a portfolio it is important to provide a suitable level of diversification across high quality companies. This will provide greater potential for the total dividend payments to increase from year to year as companies generate profit growth. Dividends may therefore have a significant advantage over other forms of income in an inflationary environment, as they allow the investor to maintain the real value of their income stream over time.
By way of example, consider the annual interest on $100,000 invested in bank bills compared to the dividends from a $100,000 investment in Woolworths (WOW) shares on 1 July 1994.
As can be seen in the graph above, over the long term the share investment has provided an attractive growing dividend stream far outweighing cash interest. This does not take into account other potential benefits such as capital growth and franking credits.
Falling term deposit rates and the recent share market weakness makes the current dividend returns from blue chip stocks very attractive. The table below highlights the forecast dividend yields.