What Are Dividends?
Dividends are payments from profits or retained earnings that corporations pay their shareholders, as approved by their board of directors.
When a company generates a profit, it can be either reinvested in the business or distributed to its shareholders in the form of dividends.
Companies determine dividends based on the current year’s profits as well as the retained earnings of prior years. A corporation is not expected to pay dividends out of its capital.
The value of a dividend is allocated on a per-share basis. Management typically issues dividends in the form of cash. However, the payment can be made as shares of stock or other property.
For most shareholders, the dividend amount and the yield are important metrics to consider. The yearly dividend amount per share divided by the stock’s current price is the dividend yield. For instance, if a company has a dividend yield of 4% per year, it means that it pays an annual dividend of £80 against £2,000 worth of shares.
Depending on the jurisdiction of the investment, dividends received by shareholders could be considered income and are generally subject to taxation. However, there could also be some exemptions. For example, in the U.K., distributions as part of a retirement plan, such as a self-invested personal pension (SIPP), might follow different taxation rules.
Which Stocks Pay Dividends?
Companies that pay regular dividends are typically more established, large-capitalization (cap) businesses. Their boards maintain dividend payments as they aim to improve the returns to their shareholders in addition to annual growth. For example, most of the 30 large-cap members of the Dow Jones Industrial Average Index and around 80% of businesses in the S&P 500 Index currently pay dividends. In the U.K., all but three of the members of the benchmark FTSE 100 index are forecast to pay dividends in 2022. This percentage is likely to stay stable in the foreseeable future.
Companies in specific industries typically hold a more sustainable record of dividend payments. Examples include utilities, financial services, healthcare, and telecommunications.
Publicly-traded firms in the U.S. that have increased their dividend payments consecutively for at least the past 50 years are known as “Dividend Kings.” In the U.K., 42 stocks listed on the benchmark FTSE 100 index cut their dividend in 2020/2021 due to the pandemic.
Next in line are “Dividend Aristocrats,” which in the U.S. have boosted their dividend payments consecutively for at least 25 years.
The criteria are slightly different in the U.K., with these Aristocrats based on the 40 highest-yielding companies that have offered increasing or stable dividends for at least 10 years. Due to COVID-19, this list has fallen as low as 35 members.
Meanwhile, this is a selection of the current Dividend Aristocrats:
|British American Tobacco||(LSE:BATS)|
|Smith & Nephew||(LSE:SN)|
On the other hand, high-growth companies and start-ups may not offer regular dividends since they typically cannot spare funds to distribute to shareholders. As businesses in the early stages of development, they usually incur high costs (and even losses).
Meanwhile, early-stage profit-making and even mature companies can also refrain from paying out dividends to their shareholders. Instead, they tend to reinvest their earnings back into the business to achieve higher-than-average expansion and growth.
In summary, companies are not obliged to issue dividends. Even firms that have paid high dividends in the past may not continue to do so in future quarters if they need large amounts of cash, such as an acquisition or an operational need. Therefore, passive income seekers typically buy shares of established companies that have consistently paid and even increased dividends.
How to Invest in Dividend Stocks
Building a portfolio of dividend shares requires a review of the individual’s investment objectives. Then, depending on the risk/return profile of the investor, a wide range of dividend stocks or funds from different sectors would be available. To find dividend shares, investors could typically screen financial websites, access their brokers’ websites, or talk to qualified financial planners.
The next step would be evaluating and comparing stocks in terms of dividend yields, payout ratio, consistency, and safety. In theory, a high dividend yield could be desirable. Yet it can easily imply that the payout might be unsustainable or that the stock price is in a downtrend, increasing the dividend yield.
Picking dividend stocks among businesses with long-run dividend growth, such as Dividend Aristocrats or Dividend Kings, can help increase the income consistency.
Then comes the final step of determining what percent of the capital goes into each stock. For example, when building a portfolio of 20 dividend stocks, 5% of the capital could be invested in each. However, an investor’s objectives would help determine the portfolio allocation.
An alternative method for dividend investing is buying a mutual fund or an ETF that provides exposure to equities of dividend payers. Such funds offer instant diversification via dividend stocks within a single investment.
Mutual funds and ETFs offer regular dividends since they rely on dividend income from many holdings. Therefore, if a stock in the portfolio were to suspend dividend payments, the impact on the fund’s overall payout would not be significant.
However, potential investors should remember that funds come with an annual expense ratio, which can affect annual returns. On the other hand, it does not cost an extra fee to own stocks individually.
Examples of dividend mutual funds and ETFs include:
|SPDR S&P UK Dividend Aristocrats UCITS ETF||(LSE:UKDV)|
|iShares UK Dividend UCITS ETF||(LSE:IUKD)|
|WisdomTree UK Equity Oncome UCITS||(LSE:WUKD)|
|Vanguard FTSE All-World High Dividend Yield UCITS ETF||(LSE:VHYL)|
|Fidelity Global Quality Income ETF||(LSE:FGQI)|
Regardless of the chosen investing strategy, dividend investors can compound their wealth by reinvesting. Using dividends received to purchase extra shares can lead to long-term returns being supercharged.
While some investors reinvest their dividends manually, others use a dividend reinvesting plan (DRIP) if a given company offers the plan. A dividend reinvestment plan automatically purchases more shares of a company’s stock with cash payouts. With this simple and usually commission-free program, investors can invest their cash dividends back into additional or fractional shares of the underlying stock.
Why Do Companies Pay Dividends?
Companies pay dividends for numerous reasons, such as retaining long-term shareholders. Dividend-paying firms deliver a message regarding the firm’s prospects and potential. Put another way, regular payouts imply financial stability and managerial strength.
Many well-established companies take pride in paying dividends regardless of the stock market or industry conditions. As a result, seasoned investors typically continue holding their shares despite potential volatility in the market.
From the investors’ point of view, dividends offer a way to ensure a steady income. So, when investing, especially those seeking passive income, tend to pick the stocks of companies with a track record of regular dividends. Greater demand will usually lead to an increase in the price of a company’s stock.
Investors regard dividends as offering a steady level of cash flow. As a result, many passive-income-seekers favour stocks of companies with a track record of regular dividend payouts. Greater demand by investors usually leads to an increase in the price of a company’s shares as well.
Numerous academic research and market statistics highlight that shareholders see higher returns and lower risks when investing in dividend-payers. According to S&P Global (NYSE:SPGI), “Since 1926, dividends have contributed approximately 32% of total return for the S&P 500, while capital appreciations have contributed 68%.” Therefore, a long-term diversified portfolio should ideally include robust dividend shares.
When Are Dividends Paid?
Dividend-paying companies could make distributions monthly, quarterly, semi-annually, or yearly. Public companies tend to issue regular payments on a fixed schedule. Yet, management can also pay unscheduled dividends, such as special and extra dividends.
The dividend frequency shows the intervals at which dividend payments are made in a single business year. For example, in the US, quarterly dividend payments are more common. Meanwhile, most companies in the UK, Japan, and Australia make semi-annual dividend payments, whereas annual distributions are typically the norm in Germany.
Dividend payments follow a chronological order of events. Several relevant dates are essential for shareholders to understand:
Declaration date: On this date, a company’s board of directors announces the intention to pay a dividend. Therefore, it is also called the “announcement date.”
Cum dividend: It is not necessarily a specific day, but rather a status that signals that a dividend payment will be announced soon.
Ex-dividend date: Investors must purchase shares before this date to become a shareholder qualified for the upcoming dividend. In the US, as well as many other countries, it is typically one trading day before the record date. On this day, the company confirms the list of shareholders eligible to receive the announced dividend amount.
Book closure date: With the dividend announcement, the company also declares the date to temporarily close its books for share transfers. This is also usually the record date.
Record date: This is the date the company uses to determine the shareholders who are entitled to get the dividend. In the US, a shareholder must have bought the stock at least two trading days before the record date. It can also be called the “date of record.”
Payment date: The day on which a dividend is made and the dividend amount credited to the shareholder’s brokerage account. It is around 30 days following the record date.
What Types of Dividends Are There?
There are two main types of dividends:
Cash Dividends: In this most common method, the company pays the dividend in actual cash directly to shareholders’ accounts. The payment can be transferred electronically or paid by printed checks or cash.
Stock Dividends: A stock dividend is a dividend paid to shareholders in the form of new shares in the issuing corporation. In this payment method, companies offer shareholders the option of receiving additional shares rather than paying in cash. Stock dividends are not subject to taxation until the shares granted get sold by their owner.
However, a company is not limited to paying distributions to its shareholders in cash or shares. Other less common dividend types include:
Property Dividends: Property dividend offers an alternative to cash and stock dividends. It refers to a dividend paid to investors in assets from the issuing corporation or another corporation, such as a subsidiary corporation. In this relatively rare method, the granted securities could be of other companies owned by the issuer. However, it can also take different forms, such as investment securities, physical assets, or real estate.
Scrip Dividends: A scrip dividend is essentially a promissory note issued by a firm as a certificate instead of a cash dividend. Shareholders can choose to get their dividends later or take shares in place of dividends. This dividend type is also known as a “liability dividend.”
Liquidating Dividends: This dividend payment is issued by a business during a partial or complete liquidation process. The distribution would typically be a precursor to closing down the business. The amount mainly comes from the company’s capital base.
Special Dividends: A special dividend is simply a one-time dividend payment that management decides to make. It usually follows a strong quarter of operations when the company has sizable excess cash.
Interim Dividends: These are dividend payments made before a company’s annual general meeting (AGM) and the release of full-year financial results. Typically, interim dividends accompany a firm’s interim financial statements. This type of payout is common in countries like the UK, where companies usually make payments semi-annually.
Other: On rare occasions, different financial assets can be paid out as dividends, such as warrants, shares in a new spin-out company, options, etc.