Latest / How Canadian Markets Work / Episode 48: Dividends

Transcript

Episode 48: Dividends · How Canadian Markets Work

0:00
So imagine you own shares in a company and they
0:03
announce a dollar per share dividend. You wake
0:06
up on the payout morning, you check your brokerage
0:09
account, and there it is, cash. Yeah, it's a
0:11
best feeling. It feels exactly like free money,
0:13
like a bonus. But on the morning that the stock
0:17
goes ex -dividend, the share price drops by roughly
0:20
a dollar. It drops by the exact amount of the
0:22
dividend. I mean, assuming all other market movements
0:24
are flat that day, the market reprices the asset
0:28
because, well, cash has literally physically
0:30
left the building. Right, so the stock drops
0:32
by the exact amount of the dividend. I haven't
0:35
actually gained anything. I've basically moved
0:38
a dollar from my left pocket, which is the company
0:40
I own a piece of. to my right pocket, which is
0:44
my personal cash account. Exactly. You have the
0:46
exact same amount of wealth you had yesterday.
0:48
It's just it's sitting in two different formats
0:50
now. You have a slightly less valuable share
0:53
and a pile of cash. Wow. The the dividend doesn't
0:57
create wealth out of thin air, which completely
1:00
shatters that whole illusion of. the free money
1:02
dividend. So much of the financial media treats
1:05
dividend announcements like a company handing
1:07
out a bonus. But if we really look at the mechanics,
1:10
it's just a capital transfer. Yeah, it is. So
1:13
today on this deep dive, we're going to completely
1:16
demystify what dividends actually are. We're
1:18
going to navigate the timeline of when you get
1:20
paid. We'll expose the dangerous yield trap that
1:23
catches a lot of income investors. and will reveal
1:27
a major tax inefficiency most Canadians are making
1:30
in their TFSAs. Oh, yeah. The TFSA trap is a
1:33
big one. It is. So to understand why a dividend
1:37
functions this way, like this left pocket. Right
1:40
pocket thing. We have to look at what a dividend
1:42
actually is at its core, right? Well, it is simply
1:45
a distribution of a company's past profits So
1:48
the board of directors they review the cash they've
1:50
generated and they decide to hand a portion of
1:53
it back to the shareholders Okay, but and this
1:55
is key. They have absolutely no legal obligation
1:57
to pay it So unlike a corporate bond where they
2:00
legally owe you that interest payment on a very
2:02
specific date if they miss a bond payment They're
2:05
in default with a dividend if the board decides
2:07
to just skiv it shareholders might be furious,
2:11
and the stock might plummet, but no laws were
2:13
broken. It is an optional distribution. And because
2:16
it's a choice made by the board, it follows a
2:19
very specific scheduled timeline governed by
2:22
four key dates. OK, let's walk through those.
2:25
The first one is the declaration date. So the
2:27
board issues a press release stating they're
2:30
going to pay a specific dividend amount on a
2:33
future date. Yeah, and the moment they make that
2:35
public declaration, it officially becomes a liability
2:38
on the company's balance sheet. Oh, okay. Because
2:40
they have formally committed to paying that money
2:42
out. Then comes the second date, the ex -dividend
2:46
date. This is like the crucial cutoff, right?
2:48
If you buy the stock on or after this date, you
2:51
do not get the upcoming dividend. The seller
2:54
who sold you the stock gets to keep it. Correct.
2:57
And then the third date is the record date, which
3:00
typically lands right around the ex -dividend
3:02
date, depending on the settlement rules of the
3:05
specific exchange. Right, like T plus one or
3:07
whatever. Yeah, exactly. The company effectively
3:09
takes a snapshot of its ledger to see exactly
3:12
who is officially registered as a shareholder
3:15
on that specific day. OK. And finally, the payment
3:19
date, which is the day the cash actually lands
3:24
in your brokerage account. which is often weeks
3:27
after the record date. So let me play devil's
3:30
advocate here for a second. If the ex -dividend
3:33
date is completely public knowledge, why wouldn't
3:37
I just buy the stock today, hold it overnight,
3:39
collect the cash, and then sell it tomorrow?
3:41
That seems like a free arbitrage loophole. I
3:44
mean, that is the most common theory new investors
3:46
try to test out. Right. It feels so smart. It
3:48
does. But it ignores the left pocket to right
3:51
pocket reality we just established. When you
3:54
buy a stock the day before the ex -dividend date,
3:56
you are paying for the share plus the right to
3:58
that upcoming cash. Oh, I see. You pay a premium
4:00
for that attached right. So when the market opens
4:03
on the ex -dividend date that claimed the cash
4:05
has been officially detached, the company is
4:08
now obligated to pay millions of dollars out
4:10
of its bank account. So it is objectively a poorer
4:13
company than it was at yesterday's close. Exactly.
4:15
The cash is earmarked and gone from the valuation.
4:18
So the share price adjusts downward to reflect
4:22
that physical loss of capital. You got it. If
4:24
I buy the day before and sell the day after,
4:27
I capture the dividend in my account, but I take
4:30
a capital loss. on the share price drop that
4:33
perfectly offsets it. Perfectly offsets it. Yeah.
4:35
You capture zero economic gain. But here's the
4:39
kicker. You still trigger a taxable event. Oh,
4:43
right. Because you received a dividend and you
4:45
realized a capital loss. And those are taxed
4:48
very differently. So you just end up creating
4:49
this huge administrative headache for yourself
4:51
for no actual profit. Literally zero profit.
4:54
Yeah. OK. So if a dividend doesn't create value
4:57
out of thin air. a high dividend yield must just
4:59
be a reflection of a deeply profitable company,
5:02
right? Like the narrative is usually that they
5:04
have so much cash, they don't know what to do
5:05
with it. So a high yield means a really healthy
5:08
business. Oh man, that assumption leads directly
5:10
to what income investors call the yield trap.
5:13
The yield trap. Yeah, we really have to separate
5:15
the dollar amount of the dividend from the percentage
5:18
yield you see on a stock screener. To figure
5:20
out if a dividend is actually healthy, You cannot
5:23
just look at the yield. You have to look at the
5:26
payout ratio. Okay, so the payout ratio is simply
5:28
the total dividends paid out divided by the company's
5:31
net earnings right. It tells you what percentage
5:34
of their profit is going out the door to shareholders.
5:37
Yes. So let's look at an example. Let's say company
5:40
A, they earn $2 a share in profit and pay out
5:44
$0 .80 as a dividend. That is a very conservative
5:48
40 % payout ratio. They still have 60 % of their
5:52
profits left over to reinvest in the business,
5:55
upgrade equipment, pay down debt, all that good
5:57
stuff. And if their share price is $40, that
6:00
$0 .80 dividend gives you a yield of 2%. Which
6:03
is pretty unflashy. It's completely unflashy.
6:06
Meanwhile, Company B also trades at $40 a share.
6:09
Yeah. But they are paying a massive dividend
6:12
of $3 .20. That is an 8 % yield, which looks
6:17
incredibly attractive if you're, you know, just
6:20
hunting for passive income. Oh, yeah. People
6:22
say 8 % and they just buy. But here's where it
6:24
gets really interesting. If we look at Company
6:27
B's earnings, They're only generating $2 .40
6:32
a share in profit. Wait. But they're paying out
6:35
$3 .20. So they are paying out more than they
6:38
actually make. Yes. That is a payout ratio of
6:41
133%. They are distributing way more cash than
6:47
the underlying business is actually generating.
6:49
How does a business even sustain that? I mean,
6:51
you can't pay out cash you don't have. Well,
6:53
what's fascinating here is how they find the
6:55
money. They tap into cash reserves they built
6:57
up in previous years. They start selling off
7:00
divisions or real estate, or most commonly, they
7:02
just borrow money. Oh, wow. And this explains
7:05
why the yield is 8%. Right. Because the market
7:07
isn't stupid. Institutional investors see a 133
7:11
% payout ratio. They realize it is impossible
7:14
to maintain long term, and they start selling
7:17
the stock. Oh, because the yield is just a fraction,
7:19
right? It's the dividend divided by the share
7:22
price. Exactly. So the yield is 8 % because the
7:25
share price has collapsed, shrinking the denominator.
7:27
You nailed it. The 8 % yield is a warning siren.
7:31
The market is pricing in an imminent dividend
7:34
cut. Wow. So the trap works like this. A retail
7:37
investor buys the stock specifically for that
7:40
shiny 8 % yield. Yep. Two months later, the company
7:43
runs out of borrowing capacity. and announces
7:46
they are slashing the dividend by like 70 percent.
7:49
And then the investors yield instantly drops
7:52
to something trivial and the share price crashes
7:54
even further on the bad news just totally destroying
7:57
their principal investment. But wait if a dividend
8:00
cut is so predictable in these situations and
8:03
the market is already punishing the stock price
8:05
in anticipation of it. Why don't companies just
8:08
cut it early? Like, why prolong the bleeding?
8:10
Oh, management teams are terrified of the optics.
8:13
Really? Yeah, a dividend cut is seen as this
8:15
huge admission of fundamental failure. Boards
8:17
will resist cutting it way, way past the point
8:20
of basic financial prudence. Like, they'll just
8:22
keep the charade going. Absolutely. We can actually
8:24
see a glaring example of this in our sources
8:27
with a company called Meridian. Oh, yeah, the
8:30
Meridian case study. Yeah. That really illustrates
8:33
how far management will go to protect. the dividend
8:36
narrative. It's wild. So Meridian reported net
8:38
income of $18 million for the year. OK. So on
8:43
paper to a casual observer, they look pretty
8:46
profitable. Sure. $18 million is solid. But net
8:49
income includes a lot of non -cash accounting
8:52
adjustments, right? When you looked at their
8:54
actual cash flow statement, the money physically
8:57
entering and leaving the bank account that operating
8:59
cash flow was negative $8 million. Wait, negative
9:02
$8 million? Negative $8. The core business was
9:05
actively burning cash. Yet they still decided
9:07
to pay a $5 million dividend to their shareholders
9:11
that same year. Yes. If operations were burning
9:14
$8 million and they paid out $5 million, where
9:17
did the cash physically come from? It came from
9:20
the financing section of their cash flow statement.
9:22
Oh, no. Yeah, they went to the debt markets and
9:24
borrowed $30 million. You're kidding. No, they
9:27
took on expensive debt. committed to paying interest
9:30
on that debt for years just to hand five million
9:33
of it to shareholders as a dividend. So they
9:36
took out a loan to pay their shareholders. Yep.
9:38
Putting the long term solvency of the entire
9:41
core business at risk purely to avoid the PR
9:44
disaster of a dividend cut. That's exactly what
9:46
they did. They prioritized a short term signaling
9:49
mechanism over the long term health of the balance
9:52
sheet. Wow. This is why chasing high yields without
9:56
checking the payout ratio and the cash flow statement
9:58
is just so incredibly dangerous. Right. You might
10:02
literally be buying into a company that is actively
10:04
destroying itself just to mail you a check. That
10:07
is terrifying. Yeah. OK, so knowing the company
10:10
can actually afford its dividend is only half
10:12
the equation for an investor. Right. The other
10:15
half is what happens when that cash actually
10:17
hits your account, specifically regarding taxation.
10:20
Oh, yes. The CRA wants their cut. Exactly. And
10:23
the Canadian tax system treats corporate dividends
10:26
very differently than it treats interest income
10:28
from, say, a bond or a high interest savings
10:31
account. Yeah, so if you earn $100 in bond interest,
10:35
the government treats that exactly like employment
10:37
income. Right. It is fully taxable at your top
10:40
marginal rate, just regular income. But Canadian
10:44
eligible dividends, so dividends paid by Canadian
10:47
corporations, they get special treatment to prevent
10:51
Double taxation. Correct. Because the corporation
10:53
has already paid corporate income tax on those
10:56
profits before they decided to distribute them
10:58
to you. Exactly. I mean, if the government taxed
11:01
the company at, say, 25 percent. OK. And then
11:04
taxed you fully on the dividend at your personal
11:06
rate. That exact same dollar of economic profit
11:09
is being taxed twice. Right. It's double dipping.
11:12
So. To solve this, the Canada Revenue Agency
11:15
uses a system called the gross up and credit
11:17
mechanism. Right, the gross up. This always confuses
11:19
people. It's a bit of math. Yeah. So when you
11:23
receive an eligible Canadian dividend in a non
11:25
-registered taxable account, the government essentially
11:29
reconstructs the money to see what it looked
11:31
like before the corporation paid tax on it. OK.
11:33
They multiply your dividend by a set percentage
11:36
to gross it up. So they calculate your personal
11:38
tax bill based on that larger grossed up fictional
11:42
amount, which, I mean, that sounds terrible initially.
11:45
You're being taxed on a higher number than you
11:47
actually received in your brokerage account.
11:48
It does sound bad, but then they apply the dividend
11:51
tax credit. This credit roughly approximates
11:54
the corporate tax the company already paid on
11:56
your behalf. And it reduces your personal tax
11:59
bill dollar for dollar. Oh, OK. So the net result
12:02
of this mathematical loop is that eligible Canadian
12:05
dividends end up being taxed at a significantly
12:07
lower rate than regular interest income. I see.
12:10
In fact, for investors in lower tax brackets,
12:13
the effective tax rate on Canadian dividends
12:15
can sometimes be negative, meaning it actually
12:17
reduces the tax you owe on your other income.
12:20
That is wild. Inefficiency is a huge reason why
12:23
so many Canadian investors focus on building
12:26
portfolios full of domestic telecom and banking
12:28
stocks. Oh yeah, absolutely. But this brings
12:30
us to a major inefficiency. The government offers
12:34
this generous tax credit, but it completely falls
12:36
apart if you hold these assets in a tax -free
12:40
savings account, a TFSA. Yeah, the TFSA trap.
12:43
A tax credit by definition requires you to have
12:45
a tax bill to credit against. A TFSA shields
12:49
all of your investments inside it from taxation.
12:52
You pay zero tax on capital gains and zero tax
12:55
on dividends generated inside the account. So
12:57
if you hold a Canadian dividend stock inside
12:59
your TFSA, you receive the cash dividend. But
13:03
that highly valuable dividend tax credit is worth
13:07
absolutely Nothing. Nothing at all. It just evaporates
13:11
because there is no tax bill to apply it to.
13:13
It is entirely wasted. Holding Canadian dividend
13:16
stocks in a TFSA is like having a buy one get
13:19
one free coupon at a store where everything is
13:22
already free. That's a great analogy. You are
13:24
holding an asset with a unique, powerful tax
13:27
advantage and you are placing it in an environment
13:29
that literally cannot utilize it. It's a total
13:32
failure of asset location. Exactly. A Canadian
13:34
dividend stock thrives in a taxable, non -registered
13:37
account where you can actually use the tax credit
13:39
to lower your burden. Right. So if you stuff
13:42
your limited TFSA contribution room with Canadian
13:45
dividend stocks, You're wasting the space. You
13:48
are. You would be much better off using that
13:50
valuable TFSA room for highly taxed assets. like
13:55
interest -bearing bonds or high -growth U .S.
13:58
tech stocks where you'd otherwise face massive
14:00
capital gains taxes. Exactly. And speaking of
14:03
U .S. stocks, we should also draw a hard line
14:05
between Canadian dividends and foreign dividends
14:08
here. Right. Because the gross up and credit
14:10
system only exist to integrate the Canadian corporate
14:13
tax system with the Canadian personal tax system.
14:16
Oh, so if you buy a U .S. company, say Apple
14:19
or Johnson & Johnson, they pay U .S. corporate
14:21
tax, not Canadian. Right. The Canadian government
14:24
isn't going to give you a tax credit for taxes
14:25
paid to the IRS. That makes sense. So to the
14:28
CRA, a U .S. dividend is fully taxable at your
14:31
marginal rate, exactly like bond interest. There
14:34
is no special treatment. Wow. Furthermore, you
14:36
face a foreign withholding tax. Right, the withholding
14:38
tax. Yeah. The IRS requires American companies
14:41
to withhold 15 percent of the dividend before
14:43
it even crosses the border into your Canadian
14:45
account. So if a U .S. company pays a hundred
14:47
dollar dividend, fifteen dollars stays in Washington
14:50
and you only receive eighty five. Exactly. Now,
14:54
there are workarounds primarily utilizing tax
14:56
treaties. If you hold that U .S. dividend stock
14:59
in a Registered Retirement Savings Plan, an RRSP,
15:03
the U .S. recognizes it as a retirement account
15:06
and waives the 15 % withholding tax. Oh, nice.
15:09
But the U .S. does not recognize that TFSA is
15:12
a retirement account. Nope. So if you hold a
15:14
U .S. dividend stock in a TFSA, You lose that
15:17
15 % withholding tax forever. Just gone. You
15:21
can't claim it back. It just vanishes. It creates
15:23
this crazy layered puzzle for investors. Like
15:27
Canadian dividends are incredibly efficient in
15:30
non -registered accounts, but waste their superpower
15:32
in a TFSA. U .S. dividends are penalized in a
15:36
TFSA, fully taxed in a non -registered account,
15:39
but perfectly protected from withholding tax
15:41
if placed in an R .S .P. It's a lot to juggle.
15:44
Asset lotation is arguably just as important
15:46
as asset allocation. For sure. So given how complex
15:49
all this taxation in the left pocket and right
15:50
pocket mechanics are, a lot of investors just
15:53
sort of opt out of the active management entirely.
15:55
They just turn on a DRP, a Dividend Reinvestment
15:58
Plan. Oh yeah, DRPs are huge. Every time a dividend
16:00
hits the account, the brokerage automatically
16:02
uses that cash to buy fractional shares of the
16:05
same company. It just automates the compounding
16:07
process. You never really have to think about
16:08
it. And deo -rives are a phenomenal tool for
16:11
compounding wealth. They enforce discipline.
16:13
They happen automatically. And brokerages often
16:15
execute the deo -rive without charging trading
16:17
commissions. Right. Some companies even offer
16:20
a two or three percent discount on the share
16:22
price if you acquire the shares through their
16:24
official de -ripe. Oh, wow. But relying on a
16:27
DRIPE to simplify your life can completely backfire
16:30
depending on the account type you use it in.
16:32
Oh, yes. This raises a very important question
16:35
about record -keeping. Okay. If you run a DRIPE
16:38
inside a TFSA or an RRSP, it is perfectly fine.
16:43
The government doesn't track individual trades
16:45
inside registered accounts. Right, because it's
16:47
sheltered. Exactly. But if you turn on a DRP
16:50
in a non -registered taxable account, you are
16:52
creating an administrative burden that catches
16:54
investors off guard years down the line. Why
16:57
is that? Oh, because every single time that dividend
17:00
is automatically reinvested, the government views
17:03
it as a brand new purchase of shares. Yes. And
17:06
every time you purchase a show, it changes your
17:07
adjusted cost base, or ACB. ACB? Yeah. The ACB
17:11
is the weighted average price you paid for all
17:14
your shares of a particular stock. When you eventually
17:17
sell the stock, you subtract your ACB from your
17:19
selling price to calculate your capital gain.
17:21
Which dictates your tax bill. Exactly. OK, so
17:24
if I buy a bank stock, hold it for 15 years in
17:27
a taxable account, and have a quarterly DRP turned
17:30
on. Yeah. That is 60 separate. tiny purchases
17:34
of fractional shares. 60 individual transactions
17:37
happening at 60 different market prices over
17:39
a decade and a half. And you are legally required
17:43
to calculate the exact weighted average of all
17:45
of them to determine your ACB. Oh my gosh. Yeah.
17:48
And many investors completely ignore this. I
17:50
would. They sell the stock 15 years later, their
17:53
accountant asks for their adjusted cost base,
17:55
and they realize they have to dig through a decade
17:57
of archived PDF brokerage statements, trying
18:00
to build a massive spreadsheet to track 60 microscopic
18:04
fractional share purchases. So unless you are
18:07
meticulous with a spreadsheet from day one, running
18:11
a DRIP in a taxable account is just a recipe
18:15
for a massive headache. The automation on the
18:18
front end creates a manual nightmare on the back
18:20
end. It really does. We spent a lot of time on
18:22
the mechanical realities of dividends, right?
18:24
The tax inefficiencies, the lack of free money,
18:27
the ex -dividend drop. But we have to acknowledge
18:29
why they remain so popular beyond just, you know,
18:32
the desire for cash flow. True. We mentioned
18:35
earlier how brutally the market punishes a company
18:38
that cuts its dividend. Yeah, the share price
18:40
plummets and management completely loses credibility.
18:43
Like Meridian taking on terrible debt just to
18:46
avoid that scenario right and because the punishment
18:48
for a cut is so severe the opposite action initiating
18:52
a new dividend or raising an existing one carries
18:54
enormous weight okay it is one of the most highly
18:57
credible signals a management team can send to
18:59
the market because talk is cheap Like a CEO can
19:03
go on an earnings call and project massive growth,
19:06
paint a rosy picture, and hype up the stock.
19:08
But actually, parting with cash requires reality
19:12
to match the rhetoric. Exactly. When a board
19:15
of directors votes to raise the dividend by,
19:17
say, 10 percent, they are permanently increasing
19:21
the amount of cash draining out of the company's
19:23
treasury every single quarter in perpetuity.
19:26
They would only commit to that structural drain
19:28
if they were absolutely, fundamentally confident
19:31
that their future cash flows could sustain it.
19:34
This signal is credible specifically because
19:36
it would be so painful to walk it back later.
19:39
It's basically putting their money where their
19:40
mouth is. Exactly. Okay, so let's pull all of
19:43
these threads together. Let's do it. The ex -dividend
19:45
drop proves that a dividend isn't some magical
19:48
creation of wealth, right? It's just moving capital
19:52
from the corporate balance sheet to your personal
19:55
account. A massive yield is often a mathematical
19:58
warning sign that the market expects a cut. So
20:01
always check the payout ratio. The Canadian dividend
20:03
tax credit is a powerful tool to avoid double
20:07
taxation. But it is completely useless if you
20:10
hold those assets inside a TFSA. Wasted space.
20:14
And while DIPs are great for compounding, using
20:18
them in a taxable account requires rigorous tracking
20:21
of your adjusted cost base to avoid a huge nightmare
20:24
at tax time. Yeah, that pretty much covers it.
20:27
Though I do want to leave you and the listeners
20:29
with a slightly provocative thought that kind
20:31
of builds on everything we've covered regarding
20:33
that left pocket to right pocket reality. Oh,
20:36
I love a provocative thought. Let's hear it.
20:38
OK, so we established that in a taxable account,
20:40
a dividend forces you to pay tax in the year
20:42
you receive it, whether you actually needed the
20:44
cash to live on or not. Right. It forces a taxable
20:47
event on the company's schedule not yours. Exactly.
20:50
You lose control over when you are taxed. Yeah.
20:53
Now consider a highly successful massive company
20:56
that generates billions in free cash flow but
20:59
refuses to ever initiate a regular dividend.
21:01
People get so mad at that. Many income investors
21:04
do get very angry at this. They demand the company
21:06
distribute the cash. But if a dividend is just
21:09
moving money from the left pocket to the right
21:11
pocket and triggering a tax bill in the process,
21:15
might a company actually be doing the investor
21:18
a bigger favor by not paying a dividend? Oh,
21:21
interesting. So if they aren't paying it out...
21:23
What is the alternative that benefits the investor
21:26
more? Well, they can return capital via share
21:29
buybacks. By purchasing their own stock on the
21:32
open market and retiring the shares, they reduce
21:35
the total supply. Your remaining shares instantly
21:39
represent a larger ownership percentage of the
21:41
company, and the share price naturally goes up.
21:44
Oh, so this increases your wealth without triggering
21:46
an immediate tax bill, allowing the capital to
21:49
compound tax deferred until you decide to sell.
21:52
Exactly. Or they could simply aggressively reinvest
21:55
that cash into research development or acquisitions
21:57
to drive the valuation of the business higher.
21:59
That makes a lot of sense. If the money is compounding
22:02
faster inside the company's left pocket shielded
22:04
from immediate taxation than it would in your
22:06
right pocket after the government takes its cut,
22:09
demanding a dividend might actually be demanding
22:11
to be made poorer over the long run. Wow, it
22:14
completely flips the script on the assumption
22:16
that a dividend is the ultimate goal of investing.
22:20
It really does. It just comes down to whether
22:21
you want that capital compounding tax -free internally
22:24
or generating a tax bill externally. That's the
22:28
real question. Well, that gives us a lot to think
22:29
about. Thank you so much for joining us for this
22:31
deep dive, and we will see you next time as we
22:35
continue to pull back the curtain on the mechanics
22:37
of the market.