Interactive Investor

Quick guides

What are dividends?

Whether pocketing the cash or reinvesting, dividends can be the jewel in a portfolio’s crown.

A dividend is a distribution of a portion of company profits to its shareholders. 

Dividends can add to a healthy investment portfolio. There’s plenty of reasons why it’s a good idea to invest in a dividend paying company.  

We’ll dive into types of dividend payments, how they work, yield, and plenty more. 

What is a dividend? 

A dividend is the distribution of a company's earnings or profits to its shareholders. Think of it as a reward thanking shareholders for investing in a company's shares. Regular dividends builds trust between a company and its shareholders, thus securing future investment.

Dividends can be paid at a set time each year, either annually, quarterly or monthly. The schedule is determined by a company's board of directors.

A company can even pay out a non-recurring 'special dividend'. In 2023, Billington Holdings (LSE:BILN) released a surprise special dividend of 13p per share on top of their normal 20p per share after a strong year of performance.

Larger, more established and stable companies tend to make regular dividend payments. Smaller companies, especially start-ups, may not offer regular dividend payments. Instead, they will focus on retaining funds for research and development or business expansion.

How do dividends work? 

A company’s board of directors decides whether to pay dividends, how much to pay, and when to pay them. Factors they consider include the company's profitability, cash reserves, future investment plans, and overall financial health. Companies can release dividends in three different ways:

Regular dividends: These are paid on a consistent schedule (e.g., quarterly, semi-annually). They are planned and expected by shareholders.

Special dividends: Issued on a one-off basis when a company has excess cash from unexpected earnings.

One-off dividends: Similar to special dividends, these are not regular and are paid out under specific circumstances decided by the board.

Payment process

The dividend payment process generally follows these steps:

  1. Announcement Date/Declaration Date:  the board of directors announce an upcoming dividend. The announcement includes the dividend amount and the record and payment dates. The declaration is a commitment, but it still has to be approved by the shareholders.
  2. Ex-Dividend Date: Investors must buy shares before the 'ex-date'. Investors who buy shares on or after the ex-date will not get the declared dividend and will have to wait until the next distribution period. For example, if the ex-dividend date is 1 April, investors need to buy shares before close of markets on the last trading day of March.
  3. Record Date: On this day the company determines which shareholders are entitled to receive the dividend. The record date is typically one trading day after the ex-dividend date.
  4. Payment Date: This is the date on which the dividend payment is actually made to the shareholders. It is usually about a month after the record date. For instance, if the record date is 2 April, the payment date might be set for the beginning of May. On this date, the dividend is paid either through direct debit, by cheque or straight into a dealing account.

Knowing these dates allows investors to make informed decisions about when to invest in a particular stock.

Calculation of dividend payments

Companies typically decide how much they can afford, or want to pay as dividends, then shareholders multiple that pounds and pence dividend by the number of shares they own.

For example, assume a company pays a dividend of 5% per share. If the share price is £2 and you own 200 shares, the dividend payment would be calculated like this:

Dividend per share = £2 (Share price) x 5% (Dividend rate) = £0.10 per share (Dividend per share)

Total Dividend = £0.10 (Dividend per share) x 200 (Number of shares) = £20 (Total Dividend)

Therefore, if you own 200 shares, you would receive a total dividend of £20.

Remember...

Dividends can be a sign of a company’s stability and profitability. Dividend-paying stocks do attract investors seeking regular income. 

However, not all companies pay dividends. This is true for those in earlier stages of growth or those reinvesting profits into expansion, research, and development. 

Dividend payments are also not guaranteed. They can be reduced or stopped at any time depending on the company's performance and cash flow needs.

Types of dividend payments

Let’s take a closer look at the types of dividend payments.

1. Cash dividends

The simplest and most common form of dividend payment. Cash dividends are paid directly as cash/cheques or through electronic funds transfer to shareholders. Companies with stable earnings and excess cash typically offer cash dividends. For shareholders, these dividends are usually taxable as income in the year they are received.

2. Stock dividends

Some companies choose to give additional shares of stock to existing shareholders. It allows companies to reward their investors but conserve their cash for operational needs or expansion. For shareholders, stock dividends are not taxed until the shares are sold. However, while stock dividends increase the number of shares held, they can dilute the share value.

3. Scrip dividends

Companies sometimes give shareholders the opportunity to take the dividend in the form of shares rather than cash. This scrip dividend means the company has more available funds to invest back into the business.

4. Property dividends

Companies can choose to distribute assets other than cash or stock to shareholders. These assets could include physical goods, investments in other companies, or any other items of value owned by the company. The dividends are assigned a fair market value and distributed accordingly. This type of dividend might be used when companies wish to divest non-core assets or lack liquid funds but still want to provide value to shareholders.

5. Liquidating dividends

Liquidating dividends occur during the partial or complete liquidation of a company. These dividends are paid from the capital base of the company, rather than from earned income, and represent a return of the shareholder’s original investment. Therefore, they are typically not taxable as long as the dividend does not exceed the shareholder's cost basis in the stock.

How to tell if a dividend is good 

You can tell if a dividend is worth the investment by evaluating its size relative to the stock price. Then ask yourself: can the company continue to afford these dividend pay-outs? To help you decide, you need to look at the dividend yield, the dividend coverage ratio, and the pay-out ratio. 

What is dividend yield?

The dividend yield is a financial ratio that tells you how much a company pays out in dividends each year. It's measured relative to the company stock price.

Read more: How are stock prices determined?

To calculate yield, divide total dividends paid in a year by the share price, then convert it to a percentage.

For example, Company A's shares cost £5 (500p) each, and it has paid two dividends totalling 40p each in the past year. The total dividend paid per share is 80p. The yield is calculated using this formula:

Dividend Yield= [80 (Total annual dividends) / 500p (share price)] = 0.16, so a company has a dividend yield of 16%. 

This means for every pound invested in Company X, an investor would get 16p back in dividends every year. The higher the dividend yield, the greater the return on investment. 

A higher yield may mean higher risks. A struggling company may raise its dividends to attract investors, when the share price falls the yield may rise. 

Dividend coverage ratio and pay-out ratio

If you’re relying on dividend income, the sustainability of dividends is crucial. This is where the dividend coverage ratio and pay-out ratio come into play.

Dividend coverage ratio

This ratio tells you how many times a company can afford its annual dividend payment with its net earnings. It is calculated as: 

Dividend Coverage Ratio = (Earnings per share) / (Dividend per share)

A coverage of less than 1.5 might be a red flag, meaning the company may not afford its dividends if earnings decline.

Pay-out Ratio

Pay-out ratio is the opposite of coverage ratio. This ratio shows you what percentage of earnings is distributed to shareholders as dividends. It is calculated as:

Pay-out Ratio = [(Dividend per share) / (Earnings per share)] x 100

A lower pay-out ratio suggests a company keeps a larger portion of its earnings for reinvestment or debt repayment and emergencies or setbacks. On the other hand, a high pay-out ratio could mean the company is returning more earnings to shareholders at the expense of future growth and stability.

Both calculations help test whether a company is paying dividends within its means. An ideal investment has a healthy dividend yield, a high coverage ratio and a decent pay-out ratio.

This ensures the dividends are both attractive and sustainable.

To decide whether a dividend is worth the investment, investors should consider dividend yield as part of wider research.

Do all companies pay dividends? 

Companies that regularly pay dividends are often in mature industries. High cash flow is consistent, and large-scale growth investments are less frequent. Such sectors include:

  • Oil and gas: These companies often generate substantial and relatively stable cash flows.
  • Banks: Financial institutions often return a portion of their profits to shareholders.
  • Pharmaceuticals: With long product lifecycles and strong cash flows once drugs are approved, pharmaceutical companies are able to offer consistent dividends.
  • Utilities: Utility companies usually have stable demand and regulated returns.

These sectors are typically less volatile and have predictable earnings. This makes them appealing to investors seeking regular income through dividends.

Companies that are growing may choose to not pay dividends and reinvest earnings into research. Investors therefore benefit from increased stock value, rather than dividends.

Reinvesting dividends or cashing them in 

Reinvesting dividends or cashing them in is an important choice for investors. Here’s a breakdown of the pros and cons of each approach.

Cashing in dividends

Pros:

  • Immediate income: Cashing in dividends give you an immediate income. This can be particularly beneficial in retirement or for those needing regular income.
  • Flexibility: You can use the cash to invest in other opportunities and diversify your investment portfolio.
  • Investment choice: Cashing dividends allows you to actively manage how and where your money is reinvested. You can choose to invest in different sectors or assets according to changing market conditions and investment goals.

Cons:

  • Potential for lower returns: If the cash isn’t reinvested wisely, it might not keep up with inflation.
  • Missed compounding benefits: By not reinvesting dividends, you miss out on the power of compounding.

Reinvesting dividends

Pros:

  • Compounding growth: Reinvesting dividends allows you to buy more shares. This can significantly boost the value of your investment over time through compounding.
  • Convenience: Many companies offer a Dividend Reinvestment Plan (DRIP). This automates the process of buying additional shares with the dividends paid. Often this is done without transaction fees and sometimes at a discount.
  • Long-term wealth: For long-term investors, dividend reinvestment can substantially increase portfolio growth. Investors can harness both the rise in stock prices and the increase in the number of shares held.

Cons:

  • Overexposure: Reinvesting dividends into the same company can lead to a concentration of your investment in a single company or sector. This increases your risk if that company or sector runs into trouble.
  • Lack of control: Automatic reinvestment means you’re buying shares at whatever the current price is, regardless of whether the shares are undervalued or overvalued at that time.

The choice between reinvesting dividends and cashing them in depends on your financial goals, risk tolerance, income needs, and investment strategy.

If you’re focused on building wealth over the long term and don’t need the income immediately, reinvesting dividends can be a powerful strategy.

However, if you require regular income or wish to have more control over how your returns are invested, cashing in dividends could be more appropriate.

How does dividend tax work?

Understanding how dividends are taxed is crucial for managing your investment income efficiently. In the UK, dividends are subject to tax.

Dividend tax-free allowance

In the UK, there is a dividend tax-free allowance, which means the first £500 of your dividend income in the tax year 2024-25 is tax-free. This allowance applies regardless of your other income. 

If your total dividend income goes over the allowance, the excess is taxed at different rates depending on your income tax bracket:

  • Basic rate taxpayers: Dividends that fall within your basic rate tax band (above your allowance and up to £50,270 in the 2024-25 tax year) are taxed at 8.75%.
  • Higher rate taxpayers: Dividends that fall within your higher rate tax band (above £50,270 and up to £150,000 for 2024-25) are taxed at 33.75%.
  • Additional rate taxpayers: Dividends above £150,000 are taxed at 39.35%.

ISA and SIPP dividend tax benefits

Tax-efficient accounts like an ISA or a SIPP can minimise the tax impact on your investment income. Find out more about:

How to invest in dividend-paying stocks 

Dividend-paying stocks can generate regular income from investments, as well as for building a portfolio aimed at long-term growth. Here’s a step-by-step guide on how to get started with investing in dividend-paying stocks:

Purchasing individual stocks

  • Research: Look for companies with a history of stable and increasing dividends. Sectors known for strong dividend payments include utilities, consumer goods, and real estate.
  • Financial health: Check the company’s financial statements. Look at their cash flow, debt levels, and earnings stability.
  • Market Conditions: Economic factors can affect companies differently. For instance, cyclical industries may cut dividends during economic downturns.

Investing in mutual funds

  • Dividend mutual funds: These funds invest in a basket of dividend-paying stocks. They providing instant diversification across various sectors or regions.
  • Research fund performance: Check historical performance, fund management strategy, and fees.
  • Understand the fund’s focus: Some funds might focus on higher yield dividends, while others on dividend growth.

Investing in ETFs

  • Dividend ETFs: Similar to mutual funds, dividend ETFs offer diversified exposure to a portfolio of dividend-paying stocks. However, they typically have lower fees and are traded like stocks, providing more flexibility.

Remember, like all investments, dividend-paying stocks carry risks. It’s important to research and consider speaking to a financial advisor to align your investment choices with your overall financial goals.

How to find stock that pays dividends 

Finding stocks that pay dividends involves doing your research to identify which companies offer the best potential for reliable and sustainable dividend payments. Here's how you can go about finding these stocks:

1. Financial news websites

Websites like ours provide valuable information on stocks, including those that pay dividends. These sites feature regular articles on the latest developments in the stock market, including updates on companies known for paying dividends. Our own in-house team of financial journalists and experts publish daily on ii’s stock market news.

2. Detailed stock information on investment platforms

On platforms like ours, you can get detailed information about specific stocks.

Dividend Yield: This is listed under the stock’s market capitalisation data on the ii platform. It shows how much a company pays out in dividends each year relative to its share price.

In-depth analysis: We offer analysis from reputable sources like Morningstar, providing deeper insights into a company's financial health, dividend consistency, and growth potential.

3. Stock Exchange Websites

Many stock exchanges around the world provide comprehensive data about the companies listed on them. This can include their dividend histories.

For example:

NYSE & NASDAQ: These American exchanges offer data through their websites or through associated services like Nasdaq's Dividend Calendar which helps investors track when dividend payments are expected.

London Stock Exchange (LSE): This offers detailed financials for listed companies, including historical dividend data.

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