#AskAdam – Question 7 – Dividends & Interest

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Q.

Hi Adam. I’m very new to asset buying etc and your posts have helped me (hopefully) understand things a lot more, so thank you.I guess my question is kind of broad, but how does dividends/interest work within ETFs? Do these get dished out to those that hold shares in these funds? Also, how much consideration do you, personally, put into income from investments (outside of growth) when making decisions on what funds to invest in, and even vs investing in individual companies?Keep up the great work!Thanks, Sam

A.

Hi Sam,

Thanks so much for the question.

I’ll answer it in 2 parts:

Part 1 – Dividends and Interest

You’ll find funds and ETFs have 2 types, accumulation and distribution. 

Accumulation keeps all of the dividends and interest made and reinvests it back into the ETF.  The great benefit is the compounding return that you’ll get on the incomes.

Distribution will pay the dividends and interest out to you rather than being invested.  You then hold that money in cash and do with it what you wish.

Which one is better?

This really depends on your goals. 

If you need a top up on your income then you can opt for distribution.  If capital growth is the main focus then accumulation would work best.  

Usually accumulations are better as the compounded returns help the capital growth, and then, should you need an income, you can sell some of your units each month.

Part 2 – Income Consideration

I take into account income payments when buying a company but not so much when buying an ETF.  

I don’t actively look for high income producing companies because my main focus is capital growth.  Someone who has an income focus may want to look for high income producing companies.

I do like to make sure the dividends that are paid by the company are sustainable though. If they aren’t it could have a negative impact on the share price.

Dividend Cover

I’ll consider the dividend cover which is the earnings per share (EPS) divided by the dividend per share (DPS). It shows how many times a company can pay dividends from net income. A ratio of 2 and above is good, anything less may be cause for concern.

A company with a low dividend ratio will struggle to continue paying the dividend if profits decrease.  This could impact the share price.

Payout Ratio

The other ratio I look at is the dividend payout ratio which is the opposite to the dividend cover.  It is the DPS divided by the EPS.  It shows the % of earnings being paid out in dividends. A company with a high ratio may have trouble maintaining the dividends paid. Above 50% is generally less favourable, below is more favourable. 

Final Comments

I consider the dividend yield and the total income payments made, and if i can find a company that meets my growth criteria that also has good income prospects then even better.

For me capital growth is more important than income payments.  The companies that reinvest their money into future growth is key for me. Due to this I often have companies that pay a low income in my portfolio.

To read up more on ETFs click here.

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