Dividends: what are they and why should you take notice?
We’ve all heard of things “paying dividends”: a good education, a regular fitness regime or healthy diet, a new raincoat.
It usually means that for some initial effort, cost or discipline you are rewarded with a greater benefit at a later date.
In the world of investing, a dividend is a reward paid to shareholders from a company’s earnings.
What are dividends?
The cash payment, which is paid to shareholders by a company from its profits, could be paid annually, bi-annually or sometimes quarterly.
If you hold a share that pays a dividend (and most leading stocks do although in very different quantities), you could receive a dividend “pay-out”.
How are dividends calculated?
Dividends can be expresses as a monetary amount per share, for example “the dividend on Big Brand is 50 pence”.
But usually the dividend is described as a percentage of the share price. In this case, if Big Brand’s share price is £5.00 that means the company is paying a dividend of 10%.
This is also known as the stock’s yield. The dividend yield is how much a company has paid in dividends over a year.
So how big will my pay-out be?
This is the dividend multiplied by the number of shares you hold. In this example, if you have 100 Big Brand shares your annual dividend pay-out will be £50. This may be split into two and paid bi-annually.
Put another way, if your shareholding is worth £500 and the dividend yield is 10%, your pay-out will be £50.
So I get paid for simply owning a stock?
Yes, that is one way of looking at it. It is a company’s way of rewarding loyal investors for the risk they take in holding the shares.
Some investors also choose to receive their dividends as new shares – so their shareholding grows each year without having to buy any new shares. This is called re-investing dividends and can be a very powerful way to boost investments.
So there doesn’t seem to be a downside – just buy shares that pay high dividends?
Well that is a strategy that some investors adopt – it is called income investing. But it’s not quite so straightforward.
A company might be paying high dividends because it has no good new projects to reinvest its profits in, which could be an indication it’s not doing so well.
Also, dividend-paying companies tend to be larger, established companies that have already grown to their optimum size so their share price might not see much growth.
Finally, be careful of rating a stock by its yield alone: the yield percentage will go up when the share price falls, so a high yield might be due to a low share price, not a big dividend.
It’s important to remember chasing high dividend stocks has risks. Investors could face losses if the dividend is cut and the share price falls.
Ok then, so target stocks that pay dividends but also have growth potential?
Well that is the investing Holy Grail, but not one that’s easy to track down. Investors often hold shares for different reasons.
They may hold some shares for the dividends, but are not expecting too much growth. Conversely, other shares may be held that do not pay a dividend, but which may have the potential for price growth.
As we mentioned above, companies that have typically paid dividends can reduce or cancel their pay-outs. It is useful to know how strong profits are and what proportion is paid out as dividends.
If low profits barely cover the dividend that could be a sign that pay-outs will stop.
It sounds like I need some help here…
Investing in individual shares is a risky business and requires a lot of research and dedication.
Small investors (ie individuals) seeking income can look towards funds to spread the risk, in the hope that an expert fund manager makes the right calls.
However, you will pay a fee for that expertise. There are also low-fee passive funds that prioritise income over growth. Managed or passive, these funds will typically have “income” or “yield” in the title.