What are dividend stocks and how do dividends work?
Updated
August 28, 2024
Find out what dividends are and how they can contribute to the growth of your investment portfolio.
Dividends are one of the most important parts of investing. Some investors love them. Others try to avoid companies that pay them.
There are lots of reasons for this and understanding more about dividends can help you figure out how you want to approach them when you make your own investment decisions.
Before we begin, it’s worth explaining what a dividend actually is.
Dividends are a portion of a company’s earnings that are paid out to shareholders. Some of the most popular shares in the US and UK pay them. Others don’t.
Most of the time, shareholders will receive their dividends in cash but they can also be given more company stock instead of money.
Larger, more established companies are more likely to pay out dividends. The reason for this is they can afford to do it. A startup or small business will need to use a large chunk of its earnings to build products, hire new staff or expand operations. That means paying dividends would likely be a poor use of cash and possibly even damage the company’s future prospects. Conversely, a big company like Barclays is less likely to need or want to do those things so they can afford to take a part of their earnings and pay them out to shareholders.
There are quite a few nuances to dividends and we’ll get to them shortly.
But a simple way to think about the dividend payment process is:
Dividends are usually described on a per share basis. So if you see a company saying it’s going to pay out a 5p dividend, it means you’ll get 5p for every share you own in the business.
There are a few different types of dividend, although some are much more common than others and the likelihood is you’ll only have to deal with a couple.
Cash dividends are by far the most popular form of dividend and you’re most likely to be dealing with them when you invest in companies that pay dividends. The majority of this guide will be focused on them for this reason.
As their name suggests, cash dividends are real money payouts that companies make to their shareholders. A company earns money and will pay a certain portion of it out to shareholders as a bit of a thank-you for sticking around.
Stock dividends are different to cash dividends because shareholders don’t receive any money. Instead they get more shares in the company. For instance, a 5% stock dividend would mean you get 5 more shares in the company for every 100 shares you own. This can benefit the company as it means they don’t have to pay out cash.
For shareholders there are both positives and negatives.
Because a company issues new stock to pay this type of dividend, it means the total number of shares in issue has increased. The result is your shares will fall in value in proportion to the number of newly issued shares. That’s slightly different to cash dividends where, although the share price may fall in line with the cash paid out as a dividend, you actually have physical cash as a result.
A scrip dividend is an offer from a company to pay a stock dividend, as opposed to a cash one. The company issuing the scrip dividend will give you a choice between the two. Either you can take cash or you can receive shares instead.
There is nothing inherently good or bad about paying dividends. Some great companies pay them, other terrible ones don’t.
Similarly, there are plenty of very successful companies which have never paid dividends and some underperforming businesses that still do.
That means you have to look at each company individually and try to figure out why it’s paying that dividend.
The most common reason companies pay dividends is because they have turned a profit and have nothing more productive to do with the cash than returning some of it to shareholders. That’s why dividend payers tend to be larger or more established businesses. They’re less likely to be pursuing massive expansion projects that would require substantial investment. As such they’re better able to pay out their earnings to shareholders.
One problem with this, and something which investors should be careful of, is some companies can become so relied upon to pay dividends that they feel pressured by shareholders to do it, even if it may not be in their best interest.
For example, when HSBC was advised by UK authorities not to pay a dividend during the coronavirus pandemic in 2020, some shareholders weighed up suing the company to try and force them to pay anyway. Obviously that’s rather an extreme example but it illustrates how some shareholders’ demand for dividends at all costs could negatively impact a company.
Paying out dividends to what may amount to hundreds of thousands of shareholders takes some organising. That means there is a structured process to dividend payments and understanding them may mean you don’t end up losing out or getting overly anxious about late payments.
This is where the company officially announces it’s going to pay a dividend. It will also announce the ex-dividend date and payment date.
The ex-dividend date is the day on which share buyers cease to be eligible for the upcoming dividend payment. If you buy a share on or after the ex-dividend date then you won’t receive the following dividend payment.
Similarly, if you sell your shares before the ex-date then you won’t receive the following dividend payment. But if you sell them on or after the ex-dividend date then you will get the dividend.
The record date is where the company looks through its shareholders and determines who is eligible for a dividend and who is not. It is usually one day after the ex-dividend date.
The payment date is the day on which dividend payments are made to shareholders. This does not necessarily mean you’ll get the money on that day. Some companies still pay shareholders with cheques and the payment date is when they send those out.
Some stockbrokers also hold customer shares in nominee accounts as beneficial owners. That means they’ll receive the payment and then pass it on to you, which can mean you receive dividends after the payment date.
Dividend-paying companies typically pay out twice or four times per year. Generally dividend payments made throughout the year are called ‘interim payments’. The last dividend payment of the year is usually known as a ‘final’ or ‘full-year’ dividend payment.
Full year payments are generally larger than interim ones too.
Having said this, there is no fixed schedule for dividend payments and some companies will pay them out more frequently than others. Payment sizes are also not fixed and will depend on what individual companies choose to do.
The main reason companies don’t pay dividends is because they believe the money they have at their disposal can be used more productively than paying it to shareholders. There might be positive or negative reasons behind that.
For instance, if you are a loss-making business it would probably make more sense for you to try and use your money to start turning a profit, not pay it out to shareholders.
But even if a company does turn a profit, it may feel better about investing its earnings in product development or expanding into new markets. For example, Facebook has never made a dividend payment and that’s probably because it’s been focused on expanding and product development since its founding.
A company is likely to stop paying dividends because they either can’t afford to keep paying them or think the money could be put to better use elsewhere. This may seem similar to a company not paying them at all but there is a slight difference.
If a company is a regular dividend payer and suddenly stops paying out, that should make you a bit nervous. It may be the case that it’s found some better use for the money but if it’s indicative of wider problems at the firm then you may need to be worried about more than just losing out on dividend payments.
Dividends in the UK are taxed at different rates depending on the tax band you are in.
For the 2023/24 tax year, dividends are taxed as follows:
Tax rates can change, so always check the relevant government advice for further information on the subject.
💡 Learn more about taxes with our investment tax guide.
The UK dividend allowance lets investors earn a certain amount of dividend income each tax year and not pay tax on it.
For the 2023/24 tax year the dividend allowance is £1,000.
Again, be aware that this figure can change in the future so make sure you keep up to date with the latest guidance provided by the UK tax authorities.
If you open an ISA account and use it to invest in dividend-paying UK stocks you can also shield yourself from some taxes. The same is true of a SIPP pension account.
But remember that most non-UK stocks, including the US, will have dividend income taxed at source. So even if you buy them in a tax-efficient account, like an ISA or SIPP, you’ll still be paying that tax.
Lots of people start investing and immediately look for dividend-paying stocks. This is a natural emotion to have. We invest to make money and dividends are a source of physical cash that we can receive with some level of regularity.
But the hunt for the quick hit a top up to our bank balance provides can mean we end up picking stocks purely because they’ve paid dividends in the past.
That’s not a great strategy to have because there are plenty of firms which pay dividends but probably aren’t wonderful long-term investments.
Companies in the tobacco sector are arguably an example of this. They’ve tended to provide strong dividend returns in the past but don’t look like they have the brightest of futures.
You shouldn’t totally write off dividend investing because of this, just make sure you properly analyse any investments you make and don’t get blindsided by the allure of receiving income in return for buying shares.
A dividend yield is probably the most common metric used to evaluate a firm’s income credentials. The yield tells you how much a company pays out in dividends relative to its current share price.
Generally investors use something known as a ‘trailing dividend yield’. This tells you the total value of all the dividends paid out over the prior year as a percentage of its current share price. So if a company had shares worth 100p today and paid out 10p in dividends over the past 12 months, it would have a yield of 10%.
Investors may also use a forward dividend yield. This is similar to a trailing yield except it tells you the predicted value of future dividend payouts as a percentage of the current share price.
Both forward and trailing dividend yields are handy metrics to have. But remember that dividends can be cut, increased or cancelled at any point. Plus share prices fluctuate constantly, which will also impact yield figures.
Basically you should take these numbers as rough guides to be used in conjunction with other figures. Using past or predictive numbers to tell you how much you might make in the future always carries investment risk with it, so seeing dividend yields as cut and dry numbers isn’t likely to be a wise thing to do.
People always like to have a one-size-fits all style answer to questions like this. Alas, like so many things in life, there isn’t one.
A company could have a high dividend yield or a low one and still be a good investment. It could equally be a terrible one.
That being said, one way of thinking about this is to be a bit like the Ancient Greeks and look for a golden mean that’s somewhere in the middle.
Remember that as a company’s share price rises its yield will fall and vice versa. That means a very high yield can be a sign of a falling share price and a company with poor prospects. At the same time, income investors aren’t likely to be satisfied with a dividend yield that’s extremely low. A company that’s somewhere in between those two extremes may provide some of the stability dividend investors look for but also be a healthy business which is still likely to do well going forward.
A less looked at metric, at least compared to dividend yields, is the dividend payout ratio. This tells you how much a company has paid in dividends relative to its profit.
To calculate it you divide the total amount of dividends a company has paid by its net income. So if you imagine a firm that’s made £1,000 in profit and paid £500 in dividends then you’d have a dividend payout ratio of 0.5.
Unlike yields, which are largely about figuring out what future returns might be, the payout ratio is more about gauging how sustainable dividend payouts are. Even a large company will want to keep money away for a rainy day or to reinvest in itself, so if a firm is regularly paying out a hefty dividend that could be a sign it's not prepared for future problems.
Dividend cover is similar to the payout ratio and is commonly used to figure out how sustainable a company’s dividend payments are.
To calculate it you do the inverse of the payout ratio equation — you divide a company’s profit by the value of its dividend payments.
So if we take the company that has £1,000 in profit and £500 in dividends, you’d have a dividend cover of 2.
Again, the idea here is to figure out whether or not a company is overstretching itself and paying too much in dividends. So if a firm had a dividend cover of 1 or less that would probably set off a few alarm bells for investors.
There are plenty of websites and data providers that can tell you which stocks have the highest yields for both UK and US stocks.
One thing to be careful of is the accuracy of that data and what type of yield they are using. Mixing up a forward and a trailing yield can mean risking your money. That’s even more true for poor quality or old data, so be very careful.
Looking for companies which pay the highest dividends isn’t always a great strategy. As we’ve seen already, a high dividend yield could be a sign that a firm is in trouble or has poor future prospects.
With that in mind, remember that even though the following stocks may have some of the biggest dividend yields on UK stock market (as of 7 June 2021), that doesn’t mean they’ll continue to have those high yields or that they’re great investments.
Assuming you wanted to live on the UK average salary of £31,000 per year, and dividend yields and stock prices remained fixed, then you’d need to invest about £1m to live off dividends alone.
That’s based on the average yield of the largest 100 companies on the UK stock market being around 3.4% at the time of writing, meaning a £1m investment in a fund tracking the index would net you about that average salary figure.
A lot of investors turn to a strategy like this in retirement but with it comes an implicit acknowledgement that the value of investments, and they income they provide, can go down as well as up. Living off ‘natural income’ or using it to top up another source of income means understanding that those payments will fluctuate, sometimes massively as we saw in 2020.
The simplest method of getting exposure to dividends is to buy shares in companies that pay them.
There is nothing wrong with doing this but you don’t want to get sucked in by high yields. Dividend payouts may be a good place to narrow down your investment options but you still need to make sure the companies you invest in are going to be good for the long-run. Just looking for the best dividend shares in the UK, for example, isn’t enough.
Stocks are the most popular means by which to access dividends but lots of investors buy ETFs that track dividend-paying companies too. These tend to focus on specific regions, like the UK or US, but may also take into account other criteria, such as yields or price volatility.
It’s worth remembering that lots of ETFs pay out dividends, even if they don’t have income investment in mind specifically. For instance, an ETF tracking the largest 100 companies on the UK stock market may pay out the income it receives.
You can usually tell if an ETF does pay dividends based on its full title. An ETF that pays out dividends generally has ‘dist.’ at the end of its name, to show that it ‘distributes’ income. If you still aren’t sure then check the ETF issuer’s website and it will tell you.
Reinvesting your dividends may be one of the most important things you do as an investor.
Looking back over the past few decades, failing to reinvest dividends would mean you had a substantially lower total return.
For instance, the S&P 500 return from 1991 to 2021, with dividends reinvested, was almost double the return than if dividends weren’t reinvested. This is part of the reason some investors prefer not to have dividends paid out. They think companies can reinvest the money more efficiently themselves.
Similarly, some investors prefer ETFs that don’t pay dividends as they’ve historically provided better returns than those which do.
💡 Learn more about investing with our guide to how to buy shares.
Yes, you will usually receive dividends in proportion to the fraction you own. So if you owned half a share, you’d get half of the dividend per share paid out.
Stock splits and stock dividends are very similar. The difference lies in the goal behind it.
A stock split is usually designed to reduce a company’s share price so they’re more affordable to investors.
In contrast, a stock split is supposed to provide more equity in the company.
The thing is, in both cases new stock is issued and given to existing shareholders. The effect is such that the share price falls in proportion to the number of new shares issued. For example, a 2 for 1 stock split would double the number of shares in issue but halve their value. It’s for this reason that some investors are opposed to stock dividends, as unless the share price rises, they don't actually gain anything from it.
Dividends are listed on a company’s cash flow statement as a use of cash.
No, a company’s decision not to pay dividends tells you very little. It could be a terrible company or an amazing company. Many major US tech companies, for example, do not pay dividends. It depends on their goals and if they have big plans to put their profits to work in generating more growth, or if the firm has hit such maturity that shareholders expect a dividend policy to be in place.
Nearly all listed companies have an investor relations website or service. Checking this is a simple way to see if they don’t pay dividends. Other alternatives are to check with respectable financial data providers.
Dividends are usually paid as cash into your brokerage account. You will likely be notified when and how much you have been paid. But as dividends are cash, the money you receive will look like any other money in your account and there won’t be a separate section or part of your account devoted solely to dividend payments.
Dividends typically have a negative effect on a company’s share price. Remember that from the ex-dividend date onwards, a share ceases to have the rights to the upcoming dividend tied to it.
That means a company’s shares should, in theory, fall in price by the value of the dividend on that date. So if a company had shares worth £1 and was going to pay a £0.10 dividend then you’d expect the shares to drop in value to £0.90 on the ex-dividend date.
In the US, exchanges actually mark down the price of a share by the value of the dividend prior to the resumption of trading on the ex-dividend date. Other countries do not have the same system but market participants typically sell off to reflect the fact that the company should drop in value in proportion to the amount of money it paid out in dividends.
Lots of companies on Freetrade pay dividends and if you invest in any that do then you’ll receive that cash into your account. Alternatively you’ll receive new shares if a company performs a stock dividend.
We’ve also written a lot about dividend investment strategies and the companies that pay them, so have a read of the following if you’d like to learn more.
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