Dividend stocks allow investors to generate a cash income from their share portfolio without having to sell any shares. Buying dividend stocks can be a good strategy for retirement investors, but it can also work well for investors targeting long-term growth.
In this guide, we’ll explain what dividends are, how they work and when they’re paid. We’ll also help answer common questions such as “are dividends safe?” and “do all stocks pay dividends?”.
A dividend is a share of the annual profits of a company that is paid to its shareholders.
Dividend payments are divided up so that an equal amount is paid for every share in the company. For example, if a company has 1,000 shares and has a share price of £100, shareholders will be paid a dividend of 10p for each share they own.
When a company’s profits rise, its dividend will often rise too, providing a rising income for shareholders.
The majority of dividends are paid in cash, but companies sometimes pay stock dividends by issuing new shares to shareholders.
A dividend stock is simply a share in a company that pays dividends. Apart from this, dividend stocks are identical to all other shares. Remember, stocks and shares are the same thing.
When a dividend is paid, the money is paid automatically to all shareholders.
Companies pay dividends to return a share of their profits to shareholders. This is done to provide a return to shareholders and to prevent too much surplus cash building up on the company’s balance sheet.
Dividends are most common among larger or slow-growing businesses. These may only need to reinvest a portion of their profits each year, so they can return the remainder to shareholders.
In contrast, some smaller or fast-growing companies may not pay dividends, as they need to reinvest all of their profits to support continued growth.
There is a strict routine for paying dividends. This makes it easy for shareholders to know exactly what they will be paid and when.
Dividends can be paid annually, twice a year or quarterly. The majority of UK companies that pay regular dividends do so twice a year, through an interim and final payout. These payments are known as ordinary dividends and are usually paid at around the same time each year.
In addition to ordinary dividends, companies may sometimes choose to pay a special dividend. This is a one-off payment to return spare cash to shareholders. Special dividends can be paid at any time, subject to the procedure described above.
The tax treatment of dividends depends on an individual’s circumstances. In general, UK dividend income is taxable once a certain limit has been reached.
Dividends from foreign shares like US or European stocks may also be taxed in the country where they are paid, before they are received by UK shareholders.
Buying a dividend stock is the same as buying any other share. You’ll need to have a broker account with enough cash available for the shares you want to buy.
UK brokers will normally allow you to buy any share listed on the London Stock Exchange. Many UK brokers now also offer foreign markets, such as US stocks.
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Read the full methodologyThe dividend yield represents the value of the dividend as a percentage of the share price. It’s similar to the interest rate on a savings account. For example, if a company has a share price of 100p and pays a 5p dividend for the year, its dividend yield will be 5%.
However, it’s important to remember that the actual dividend yield you’ll receive depends on the price you paid for your shares, not the current share price.
Investors often look for dividend stocks with very high yields, but these may carry a greater risk of being cut. Very high yields are sometimes a sign of companies with falling profits or unaffordable dividends.
UK supermarket Tesco is an example of a large company that pays regular dividends. In October 2021, Tesco declared an interim dividend with its half-year results. The company provided the following information for shareholders:
Not all stocks pay dividends. There is no requirement for a company to offer dividends and it isn’t always a suitable option for the business.
In addition, some companies choose to return cash to shareholders in different ways. One common choice is through share buybacks, where the company buys its own shares in the market.
Dividend stocks are sometimes seen as a more conservative and safer choice than non-dividend-paying stocks.
However, it’s important to remember how dividends work. Payments are never guaranteed and may rise or fall from year to year. Although directors at dividend-paying companies generally try to maintain or increase their payouts each year, circumstances can change. Dividends can be cut at any time, without warning.
Like all stock market investments, dividend stocks carry the risk that you may not get back all the money you originally invested.
There are several useful indicators which can be used to check whether a dividend is likely to be sustainable.
The most popular check is to compare a company’s dividend with its earnings. If a company pays out too much of its earnings as dividends, it may struggle to invest in the business or maintain regular dividend increases.
As a rule of thumb, many investors look for earnings per share that are 1.5–2 times higher than the dividend.
Other dividend safety checks used by income investors include looking at debt levels and at the amount of surplus cash generated by a business. Too much debt is a risk factor, because debt repayments always take priority over dividends.
Dividends allow investors to choose between withdrawing income and reinvesting their cash. For investors who are still trying to build an investment portfolio for the future, reinvesting often makes sense.
There are 2 main ways to reinvest dividends. The first is using a dividend reinvestment plan, or DRIP. A DRIP allows shareholders to receive their dividends in the form of new shares in that company, rather than in cash. Not all companies offer a DRIP.
The other way to reinvest dividends is to keep the cash in your broker account and use it to buy new shares of your choice.
If you want to generate a regular income from an investment portfolio, then dividend stocks are worth considering.
Although they don’t provide a guaranteed income, dividend stocks allow you to profit from rising share prices. They can also provide a much higher income than short-term investments such as savings accounts.
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
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