How do dividends work?

Dividends are an important feature of investing and trading. But what are they, and how do they work?

Profitable companies can choose to reward their shareholders by paying out some of their earnings in the form of a dividend. This usually takes the form of a cash payment or additional shares which are typically paid out quarterly or annually, though sometimes a company will pay out a special dividend.

In cash or in shares?

If you hold shares in a company that decides to distribute cash dividends, you’ll receive payments based on how many shares you own. For instance, if the company chooses to pay a cash dividend of $10 a share and you own 1,000 shares, you’ll receive $10,000 in payments. Not bad.

The company may choose to pay a dividend out in shares. This could be because they’re currently a little short on cash but still want to keep their shareholders happy by rewarding them.

 

 

As with a cash dividend, if you are paid a dividend this way then the amount you receive will be based on how many shares you hold. For example: say that a company chooses to give a share dividend of 5%, and you own 300 shares in this company, you can expect to receive 15 more shares – 300 x 5/100.

With a share dividend, usually you won’t have to pay any tax until it’s sold, unless the share dividend has a cash-dividend option. If that’s the case, you’ll need to pay tax even if you choose to keep the shares instead of selling them. Still with us? Cash dividends, though, will be taxed straight away, which is one reason many investors prefer share dividends.

What, no dividend?

The alternative to paying a dividend is for the company to keep the cash, perhaps with a view to investing it in new plant, machinery, IT updates, staff training or acquiring a rival business. But investors have a pretty shrewd idea when profits are being frittered away, and will respond by selling their shares, so driving down the value of the company, or openly criticising corporate executives at the next shareholder meeting. But if a company is known to be a regular and reliable dividend payer, then this increases its attractiveness to investors. They will want to own shares in such a company to receive these dividend payments which can make a sizable addition to a stock portfolio, especially if they are reinvested.

You have to make a profit to pay a dividend

 

 

A company’s ability to pay a dividend rests on its profitability. Companies that tend to make steady profits, no matter what the economic conditions, can usually be relied on to pay a dividend. Such companies rarely hit the headlines. They get their reputation from performing well even during times of economic or market turbulence. In contrast, glamorous stocks like Netflix and Tesla are always in the news even though the performance of their shares relies on hopes for future growth rather than profits today.

Don’t rely on that dividend

Large banks and the oil giants had a reputation as reliable dividend payers. For many years, Lloyds Bank was one of the most popular shares to hold in a portfolio due to its large, steady dividend pay-outs. This was despite the fact that shares in Lloyds really didn’t move very much compared to other big corporate names. But this all changed during the financial crisis of 2008 when the bank was bailed out by the taxpayer. Likewise, BP was another good and reliable dividend payer. But the oil major was forced to temporarily suspend dividend payments in 2010 in the wake of the Gulf of Mexico oil spill disaster. More recently, many global corporations slashed their dividend payments following the economic chaos caused by the coronavirus pandemic.

What dividends mean to traders

 

 

A dividend payment affects the share price as there is a cut-off date when shareholders can benefit from the pay-out. After this cut-off point, the share price trades ‘ex-dividend’ and is reduced by the amount of the dividend payable. If this company’s shares are part of an index, the price of the index is affected on a proportional basis.

The overall effect depends on the share’s weighting, or importance, in that Index and if there are several large companies going ex-dividend at the same time. Every week, we publish the estimated impact that company dividends have in reducing the price of each stock index that we offer. So, you may see some adjustments on your account if you trade shares or indices.

Summary

Traders don’t just buy shares in the hope of selling them at a higher price at some time in the future. They also consider the chances of receiving a good, regular dividend. But bear in mind that not all companies pay dividends. Some companies (such as fast-growing firms) choose not to pay dividends so that they can reinvest all their profits into expansion. Netflix and Tesla are good examples, while Microsoft waited until it was valued at $350 billion before it began paying dividends.

In short, dividends reward shareholders by giving them a cut of the company’s profits. And the amount you receive depends on how much the company decides to pay out, and how many shares you hold.