Daniel Liberto
Duncan Ferris
What is a dividend?
A dividend is a portion of company earnings distributed to some or all of its investors. If you own the right type of shares and the company you invested in is doing well financially, you might end up receiving these payments on a regular basis.
Why do companies pay dividends?
Companies generally share some of their profits with investors when they have enough cash left after expenses. This practice is fairly common, particularly among big, stable corporations that generate lots of money and have no need to reinvest proceeds back in the business.
Investors have countless options for where to park their money, and a healthy dividend can make the difference in attracting their capital to support or drive up share prices. In exchange, the shareholder collects a nice loyalty bonus that, when accumulated over several years, can boost their returns.
How dividends are paid
Dividends are distributed either regularly (typically two or four times a year) or on a one-off basis. In most cases, they are declared during the course of the fiscal year (the interim dividend) and at the end (the final dividend). When a company’s board of directors agrees to pay a dividend, a set sum per share will be allocated.
Occasionally, a company may announce a special dividend, too. These are one-off payments made to shareholders, usually after receiving a big windfall, say from the sale of an asset.
There are four important dates to take note of:
- Declaration date: The day the board reveals its intention to pay a dividend.
- Ex-dividend date: Investors must buy shares before this date to qualify for the upcoming dividend.
- Record date: This is the date the company uses to determine which shareholders are invested and thus entitled to the dividend.
- Payment date: The dividend is dispensed and appears in the investors account. This is around one month after the record date.
What is a dividend yield?
The dividend yield expresses the size of the dividend relative to the share price as a percentage. It is usually calculated by dividing all dividend payments from a 12-month period by a company’s share price.
As an example, let’s say company x has shares that currently cost 400p, or £4, each. Company x has given its shareholders two dividend payments of 20p across the last 12 months. It has therefore paid 40p in total dividends across the full year. 40/400 = 0.1, so company x has a dividend ratio of 10%.
Dividend yields are closely monitored as they essentially tell how much cash you’ll get back for each pound invested in a particular holding. They should be treated with caution, though. The higher the yield, the bigger the reward – and risk of being left empty-handed.
Not all companies are prudent. Some live beyond their means, offering generous dividends, subsidised by borrowing money or offloading assets, to keep investors sweet they may paper over the cracks of an otherwise unappealing investment.
It’s also worth bearing in mind that yields rise when share prices fall: a sign of an adverse change in fortunes that could have an impact on the company’s ability to maintain payouts.
Is dividend investing safe?
Like any stock market-based investment, income on shares isn’t guaranteed. Companies aren’t obligated to deliver dividends, and in times of trouble they may have little choice but to slash or completely axe these non-essential business expenses.
No board wants to do this. Taking such action implies that finances are worsening and almost always leads numerous investors to jump ship. Sometimes, however, there is no alternative.
Because of these risks, investors are advised to do their homework. Make sure the company has a history of generating plenty of excess cash, a favourable outlook to continue doing so, and is not shackled with debt or other forthcoming expenses that may affect its ability to keep up with payments.
Track records should be scrutinised as well to identify who honours commitments and was able to maintain and even grow dividends during a rough patch.
How to determine if a dividend is sustainable
Investors have several tools at their disposal to examine the robustness of a dividend. One simple, frequently used method is to divide a company’s earnings per share (EPS) by its dividend per share (DPS).
The dividend coverage ratio measures how many times the company can afford to pay its dividend from the profits it’s making. Usually, anything below 1.5 should set off alarm bells, unless there is a reasonable explanation or the subject fits the mature, defensive company profile.
Another popular technique is the payout ratio. This metric works in the opposite way, dividing DPS by EPS to reveal the percentage of earnings dispensed to investors.
Low payout ratios, like high dividend coverage ratios, imply the subject can comfortably fund dividends, leaving it with enough money to cover any emergencies or setbacks, and strengthen its operations to the long-term benefit of shareholders.
Not all businesses are the same, though. Some are able to shell out large chunks of profits without endangering their prospects. Others can’t afford this luxury and will be expected to allocate a much smaller percentage or nothing at all to dividends.
Should I reinvest dividends?
When investing in funds and shares, it’s possible to automatically reinvest any income you receive back into the investment that distributed it.
Many swear by this strategy, arguing it represents one of the best ways to grow wealth. But it isn’t flawless and might not be suited to everyone. Speak to a financial adviser if you’re unsure of the investment strategy that could be right for you.
Do you pay tax on dividends?
Earn more than £1,000 from dividends in a year and you may need to inform HM Revenue and Customs. Payments in excess of this amount are taxed in the following way:
| INCOME TAX BAND* | DIVIDEND TAX RATE |
|---|---|
| Basic rate (income between £12,571 and £50,270) | 8.5% dividend tax rate |
| Higher rate (income between £50,271 and £125,140) | 33.75% dividend tax rate |
| Additional rate (income above £125,140) | 39.35% dividend tax rate |
Source: UK Government
*Income tax bands differ slightly for people living in Scotland
The good news is you also have access to an annual £20,000 tax cushion before these rates apply, courtesy of stocks and shares ISA. Invest via one of these accounts and you can keep every penny you make.
» MORE: Dividend Tax Explained
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
Image source: Getty Images
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