A beginner’s guide to dividends

Dividends are an investor’s friend. They make a tremendous difference to the returns generated and can be used in several ways. But what are they and how do they work?

What are dividends?

Dividends are sums of money paid to shareholders by companies out of their profits. The amounts will be decided by the board of directors.

While dividends can be paid at any time, they are usually linked to the announcement of company results. These will typically be on a quarterly basis.

However, additional dividends may be declared for extraordinary events, such as the sale of a subsidiary that has generated a significant amount of cash.

Why do companies pay dividends?

It may seem odd that companies would choose to share some of their profit – but it’s not done solely for altruistic reasons. Companies can also benefit from their own generosity. For example, rewarding investors for their support may encourage them to continue holding shares.

Paying dividends is also seen as a show of faith by a company in its future prospects. This will obviously be very attractive to potential new shareholders. Such positivity can lead to higher demand for a company’s stock, which will also help push up the share price.

Do all companies pay dividends?

No, they don’t – and they’re not required to do so.

Generally, established companies with decent revenue streams are the most likely to pay dividends to shareholders. Younger, developing firms are less likely as they want to use their financial resources to fund their ambitious growth plans.

Of course, even well-established, profitable companies may choose not to pay a dividend – or only distribute a limited amount – if they have a use in mind for the cash. For example, they may be plotting the acquisition of an associated firm or want to diversify the business into different areas.

Which sectors pay the most dividends?

Traditionally, it’s companies in stable, highly cash generative sectors that aren’t looking to grow rapidly that will generally pay the most in dividends.

Mining companies, tobacco giants and energy businesses fall into this category as there is continuous strong demand for their goods and services. But there are companies in every sector that pay dividends – including some technology companies even though they are thought of as growing businesses.

Do companies in different countries pay dividends?

Yes they do. UK companies have a long tradition of paying dividends but companies in Europe, Asia, the US, and emerging markets also pay them. In Japan there has been a concerted effort by the government over the past decade or so to encourage companies to increase their dividend payouts.

Janus Henderson issues a quarterly global dividend index, which assesses the dividend payments of companies in different sector and different countries. Jane Shoemake explains what the index incomers are in this podcast interview and FundCalibre regularly reports on its findings:

What is meant by dividend yield?

This is a financial ratio that measures a company’s annual payments to shareholders as a percentage of its current share price.

However, the dividend yield shouldn’t be the only metric considered, as it can potentially cloud what is happening in the company.

For example, a stock offering a higher dividend yield than rivals could be having problems. This is because the higher yield may be caused by a fall in the share price – in other words, the annual payment has become a higher percentage of the share price.

This is also why stock analysis is important. You may find that a company with an apparently attractive dividend yield has a track record of cutting payments during tougher times.

How to use dividends

There are several ways to benefit from dividends. Income investors may use them as an extra revenue stream to help cover the bills.

This means they don’t have to withdraw any of the capital in other investments and may be particularly attractive for those looking to supplement their retirement income.

Investors that don’t need to get their hands on this cash can look to reinvest the dividends that have been generated – and enjoy the compounding benefits.

How dividends can drive returns

Investors also need to be aware of how dividends can help drive returns. According to Fidelity International, they form an important part of the ‘total return’ of a stock investment.

“If ABC Corp’s stock price rises by 6% in a year, for example, this could represent a tidy return for an investor,” it stated. “However, if ABC Corp then pays a dividend of 4% in that year as well, the stock’s total annual return will be an even more pleasing 10%.”

The chart below from Schroders also illustrates this point. It shows the returns from the FTSE 100 – the benchmark of the UK’s largest 100 companies – without dividends and with dividends reinvested:

Potential dangers

Of course, investing in individual stocks in the hope of receiving dividends is risky.

There are no guarantees that the company will be able to make a pay-out. They may also cut the dividend completely due to hitting financial problems or responding to global problems and decide to tighten the purse strings for the foreseeable future.

You also need to pay attention to the index chosen. For example, in the FTSE 100, a relatively small number of companies are responsible for a large proportion of the dividends paid.

Going down the fund route

An alternative to buying individual dividend paying stocks is opting for an investment fund whose manager invests in a wider variety of such companies. This will reduce the risk being taken as there will be more potential dividend payers within the broader portfolio.

Actively managed equity income funds are among the best ways to access such dividend paying companies, along with portfolios focusing on global dividend paying firms.

You can research FundCalibre’s Elite Rated equity income funds via these links:

UK equity income
European equity income
Asian equity income
Global equity income