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For many investors, dividend investing is a key component of the stock market landscape. And with the right sort of portfolio, dividends can account for a significant chunk of the overall return enjoyed by stocks and shares investors.
Here’s a closer look at dividends, why companies pay them, and why it pays to know about an important stock market measure called the ‘dividend yield’.
What is a dividend?
A dividend is a regular distribution, usually in cash, paid by a company to its shareholders. The payments are normally met out of a company’s earnings in a given financial year.
Dividends tend to be paid every six months, although it’s not uncommon for them to be distributed annually or quarterly. Payments are usually made on a ‘per share’ basis. In other words, an investor who owns 1,000 shares in a company that declares a 50p dividend would receive £500.
Dividends can also be made on a ‘special’ basis. These tend to be one-off payments, where a company rewards its shareholders after undertaking a particular corporate action, such as completing a large transaction.
This could be where a business has sold off a part of its operation and wants to return some of the money it has made to shareholders.
Why do companies pay dividends?
Paying a dividend allows a company to share its profits with shareholders. This represents a gesture of gratitude for ongoing support but it is primarily an incentive for shareholders to continue holding their shares and to tempt prospective buyers of its shares.
Investors tend to view consistent dividends as a sign of a company’s strength and as an indicator that a management team has positive expectations around future earnings growth. This, in turn, makes a company more attractive to investors, which in turn helps to drive up the company’s share price.
Companies able to demonstrate a consistent and rising dividend track record are of special interest to those seeking income – from retirees looking to supplement state retirement benefits, to charities and professional money managers running corporate pension funds on behalf of thousands of employees.
Which companies pay dividends?
Companies are not obliged to pay dividends and plenty of successful businesses don’t.
Despite their multi-billion-dollar valuations, for example, neither the technology giant Alphabet (the parent company of Google), nor Meta Platforms (the business behind Facebook) currently pays a dividend.
But, of those companies that do, the amount paid in dividends might range from a large proportion of earnings – usually where a company is established and mature – to a small fraction, where a business is young and growing.
Established companies are more likely to be able to afford dividend payments, whereas early-stage businesses may decide to hold on to their earnings to reinvest in growth opportunities.
A start-up business, for example, would potentially need to use the bulk of its earnings to build products, hire staff and continue with expansion plans. In this scenario, paying dividends might be regarded as a poor use of available cash and potentially damage the business’s prospects.
Companies with a strong track record of paying dividends tend to be found in specific industrial sectors within the stock market. These include utilities, commodities, energy, and healthcare – solid businesses, in other words, with well-defined trading patterns and large customer bases, all of which points to a consistency in profits.
Some companies pride themselves on repeatedly paying healthy dividends. That said, there is no guarantee that, just because a company boasts a strong track record on paying dividends, it will continue to do so.
For example, a company planning an acquisition or other cash investment might need to change its dividend strategy and divert the money away from expectant shareholders.
The financial press often features stories of companies that have either slashed dividend payments or stopped them altogether – often to the chagrin of shareholders.
How much do companies pay in dividends?
A staggering amount – a reminder of their importance as part of the overall return produced by a business on top of its rising share price. Fund manager Janus Henderson’s Global Dividend Index says companies worldwide made dividend payments worth a colossal $327 billion in the first quarter of 2023 – a record amount.
Over the whole of 2022, Janus Henderson reported that companies paid out another record-breaking sum -$1.56 trillion – for the entire year. This marked a significant turnaround from the pandemic-blighted year 2020, when companies were forced to cut or suspend their dividend payments.
What does ‘dividend yield’ mean?
When trying to work out the potential income from a share, investors look closely at a company’s ‘dividend yield’. This is a ratio that shows how much a company (or investment fund) pays out in dividends relative to its share price.
To calculate dividend yield, divide the total annual dividend amount per share by the company’s share price. It doesn’t matter whether you do this in pounds, pence, dollars or cents, providing you’re consistent for both amounts.
Put another way: Dividend Yield = Dividend Per Share / Company Share Price
For example, if ABC plc’s shares trade at £50 and the company pays an annual dividend of £2 per share, then the company’s dividend yield is 4%.
In comparison, if rival business XYZ plc’s shares are priced at £200 and its annual dividend is £3 per share, its dividend yield is much lower at 1.5%, even though investors receive a larger amount per share.
Bear in mind that share prices fluctuate constantly, which in turn affects the yield. As a company’s price rises, so its yield falls, and vice-versa.
You can find out what dividends a company paid out per share by visiting its investors relations website page and reviewing financial statements.
What affects dividend yield?
Several factors can affect a company’s dividend yield, including stock market conditions and company performance, but the main influence on dividend yield is the company’s share price.
Remember that when a share price rises, the associated dividend yield will fall – unless a company decides to boost its dividend payout.
What is a ‘good’ dividend yield?
There isn’t a one-size-fits-all answer to this question. Dividends show that a company is in good corporate health because it has enough free cash to pay shareholders.
Two companies of similar size in the same industrial sector might normally be expected to have similar dividend yields. If one yield is a lot higher than the other, this could be a sign that it’s an attractive investment.
Alternatively, it could be a sign of trouble – a sharply falling share price, for example – which is rarely a good sign for investors. Generally speaking, investors should beware of high and unsustainable dividends.
As a rule of thumb, dividend yields of between 2% and 5% are considered strong, and anything above this can be a good buy but may also come with risks attached.
If your focus is on receiving dividend payments from the UK’s leading companies, use the overall yield on the FT-SE 100 Index – at the time of writing around 4% – for comparison purposes and as a benchmark against which to judge individual businesses.
It’s also important, when scrutinising a company’s prospects, to look at more than just the yield figure. Other factors to consider include the overall trajectory of a company’s share price, its earnings per share, and price-to-earnings ratio.
The latter, usually shortened to ‘PE ratio’ is a way to measure how highly investors value the earnings that a company produces – how much they are willing to pay for a company relative to its current earnings, which reflects investors’ expectations of future earnings growth. Read more about PE here.
Dividend funds
Dividend investing is an accepted way of producing income. But constructing and managing a portfolio of suitable shares from which to achieve this can be time-consuming.
Investors who have neither the time, nor the expertise, to tackle this task themselves could consider buying into funds that offer sustainable cash flow from a diversified selection of stocks. This feature looks in greater detail at a range of dividends-based exchange-traded funds that attempt to do such a job.
How are dividends taxed?
UK adults do not pay tax on any dividend income that falls within their personal allowance – the amount of income you can earn each year without paying tax.
You also receive a dividend allowance each year and only pay tax on any dividend income above this limit. The allowance for the tax year 6 April 2023 to 5 April 2024 is £1,000, with this amount due to be halved for the tax year 2024-25.
Note that tax is not paid on dividends from shares held within a product such as a stocks and shares individual savings account or ISA.
How much tax you pay on dividends above the dividend allowance depends on your income tax band. For the 2023-24 tax year, the dividend tax rates are: 8.75% (basic rate taxpayers); 33.75% (higher rate); and 39.35% (additional rate).
