How do dividends work?

TL;DR

  • Dividends are payments of cash or additional stock to shareholders
  • Dividends are not required and therefore a company’s board of directors can cut back on or eliminate dividend payments at any time
  • Dividends are often a sign of financial health because they are a product of the company’s excess profits
  • Qualified dividends are subject to a capital gains tax, which is often significantly lower than the federal income tax

What are stock dividends?

When you buy a share of a company, you become a shareholder or partial owner. Often, when a company is doing financially well, it will reward shareholders with regular payments of cash or additional stock, known as dividends. Many refer to dividends as passive income, because the primary prerequisite of receiving a dividend is being a shareholder of a dividend-paying company. Dividends are not a requirement, but rather a courtesy. Therefore, a company’s board of directors can decide to issue, cut back on, or eliminate dividends at any time.

Why do some companies pay dividends and others do not?

There are a few reasons why some companies pay dividends and others do not. Paying dividends is a sign of financial health; dividends signal to investors that the company has excess profits that they are willing to give to shareholders. Therefore, it is not likely that a non-profitable company will offer dividends.

This does not mean that a company’s success is contingent on them offering dividends to shareholders. Young companies often don’t pay dividends because they need to reinvest all excess profits back into the company to fuel high growth. For this reason, you will see that dividends are more common among mature companies.

While dividend payments are often a good sign, it is important to note that extremely high dividend payments could be a red flag. High dividend payouts are extremely difficult to sustain over a long period, so a person who invests in a company with high dividends accepts the risk of the company cutting back or eliminating payments at any time.

How do stock dividends payout?

The timing of a dividend payout differs from company to company. The most common cadence is quarterly, but some companies such as Real Estate Investment Trusts (REITs), pay dividends monthly. The date the company announces that they will be distributing dividends is known as the declaration date. To be eligible to receive dividend payments, an investor must own the share before a pre announced date, or ex-dividend date. If you purchase the share on or after this ex-dividend date you will not receive the dividend payment.

A dividend payment can come in two forms: stock or cash. A stock dividend pays an investor with additional stock. Therefore, if an investor owns 20 shares of a company that promises a 5% stock dividend, the investor will receive 1 additional share as annual dividend payment (5% of 20 is 1). A cash dividend pays investors with cash. Therefore, if an investor owns those 20 shares at $10 apiece ($200 in total value) and the company offers a 5% cash dividend, the investor will receive $10 as annual dividend payment (5% of $200 is $10). On the payment date, you will receive the dividend payment, in either cash or stock, in your brokerage account. Some people choose to pocket dividends, but some people choose to reinvest their dividend payments back into the company. The reinvestment of dividends can be a great way to accumulate wealth.

The way a dividend is paid out is also dependent on whether you are an owner of preferred or common stock. As the name implies, preferred stock shareholders have priority over common stock shareholders. Preferred shareholders usually receive their dividends earlier than common shareholders. Further, if a company decides to skip a dividend payment they may be obligated to pay back this dividend in the future to preferred stock shareholders. They do not have this obligation to common stock shareholders.

Taxing stock dividends

Whether a cash dividend is qualified or non qualified will determine what tax structure will apply. A dividend is considered qualified if common stock is held for a minimum of 60 days or preferred stock is held for a minimum of 90 days before the ex-dividend date. If a dividend is qualified it is subject to the capital gains tax rate which is considerably less than the federal income tax rate. If a dividend is non qualified, the capital gains tax does not apply and it is subject to the investor’s federal income tax rate.

The capital gains tax rate can either be 0%, 15% or 20% based on your annual income and marital status, whereas the federal income tax rate can fall anywhere between 10% to 37%. Within any income and marital bracket, a person will earn more after a capital gains tax than they would after a federal income tax. Therefore, for the diligent investor, dividends can provide great tax opportunities.

If you receive dividends in the form of stock, taxes do not apply.

How are dividends taxed?

Most dividend stocks pay "qualified" dividends, which, depending on your tax bracket, are taxed at a rate of 0% to 20%. That range is significantly lower than the ordinary income tax rates of 10% to 37% or more. (An additional 3.8% tax is levied on certain investment income for the highest earners.)

While most dividends qualify for the lower tax rates, some dividends are classified as "ordinary" or non-qualified dividends and are taxed at your marginal tax rate. Several kinds of stocks are structured to pay high dividend yields and may come with higher tax obligations because of their corporate structures. The two most common are real estate investment trusts, or REITs, and master limited partnerships, or MLPs.

Of course, this extra tax burden doesn't apply if your dividend stocks are held in a tax-advantaged retirement plan such as an individual retirement account (IRA). However, investing in MLPs can sometimes leave you owing taxes even on your IRA.

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What is a ‘good’ dividend yield?

It’s worth remembering that there isn’t really a one-size-fits-all answer to this question. Dividends show that a company is in good corporate health because it has enough cash after investing in its business, to pay to shareholders.

But it’s important, when scrutinising a company’s prospects, to look at more than just the yield figure. Other elements to consider include the trajectory of a company’s share price, its earnings per share and price-to-earnings ratio. 

The latter, often abbreviated to ‘PE ratio’, or simply  ‘PE’, is a way of measuring how highly investors value the earnings that a company produces. 

Two companies of similar size in the same industrial sector will normally have similar dividend yields. If one 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 great buy – but may 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 – currently just under 4% – for comparison purposes and as a benchmark against individual businesses.  

Dividend-paying companies

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.

How do dividends work?

When you own a dividend stock, the company will issue payments based on the type of dividend they offer. 

First, the company will announce the amount of each dividend and when it will be paid. When they make the announcement, they set a deadline by which investors must own the stock to get the dividend.

If you buy the stock on time, or already own it, you’ll usually receive your dividend payment via your brokerage account. Then you can spend it, save it, or reinvest it. You can also use it to buy more of the same stock, sometimes at a discount, through a dividend reinvestment plan (DRIP), which might be administered by your brokerage or by the company you hold stock in. 

Investors who buy and hold their stock typically don’t have to do much to manage their dividends after setting up their initial strategy to spend, save, reinvest, or DRIP. Last but not least, your stock class can affect your dividends. If you own preferred stock, you may be guaranteed a dividend, but it’s probably a fixed amount. Common stock holders aren’t necessarily entitled to a dividend, but they may receive higher dividends than preferred shareholders when the company’s profits grow.

Which companies pay dividends?

Companies are not obliged to pay dividends and plenty of successful businesses don’t.

But of the companies that do, the amount paid in dividends might range from a large proportion of earnings – usually where the company in question is established and mature – to a relatively small fraction, where a business is still young and growing.  

Long standing companies are more likely to be able to afford dividend payments, whereas earlier-stage businesses may decide to hold on to their earnings to reinvest in future growth opportunities.

A start-up business, for example, would potentially need to use the lion’s share of its earnings to build products, hire staff and expand. 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 with well-defined trading patterns and large customer bases, leading to consistency in profits.

Some companies pride themselves on their consistent approach to 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 investment that requires a large amount of cash might need to alter its dividend strategy accordingly.

Dividend yield and other key metrics

Before you buy any dividend stocks, it's important to know how to evaluate them. These metrics can help you understand how much in dividends to expect, how reliable a dividend might be, and, most importantly, how to identify red flags.

  • Dividend yield: This is the annualized dividend represented as a percentage of the stock price. For instance, if a company pays $1 in annualized dividends and the stock costs $20 per share, then the dividend yield would be 5%. Yield is useful as a valuation metric when you compare a stock's current yield to its historical levels. A higher-dividend yield is better, all other things being equal, but a company's ability to maintain the dividend payout — and, ideally, increase it — matters even more. However, an abnormally high dividend yield could be a red flag.
  • Dividend payout ratio: This is the dividend as a percentage of a company's earnings. If a company earns $1 per share in net income and pays a $0.50-per-share dividend, then the payout ratio is 50%. In general terms, the lower the payout ratio, the more sustainable a dividend should be.
  • Cash dividend payout ratio: This is the dividend as a percentage of a company's operating cash flows minus capital expenditures, or free cash flow. This metric is relevant because GAAP net income is not a cash measure, and various non-cash expenses can cause a company's earnings and its free cash flow to vary significantly from one period to the next. This variability can render a company's payout ratio misleading at times. Investors can use the cash dividend payout ratio, along with the simple payout ratio, to better understand a dividend's sustainability.
  • Total return: This is the increase in stock price (known as capital gains) plus dividends paid. For example, if you pay $10 for a stock that increases in value by $1 and pays a $0.50 dividend, then that $1.50 you've gained is equivalent to a 15% total return.
  • Earnings per share (EPS): The EPS metric normalizes a company's earnings to the per-share value. The best dividend stocks are companies that have shown the ability to regularly increase earnings per share over time and thus raise their dividend. A history of earnings growth is often evidence of durable competitive advantages.
  • : The price-to-earnings ratio is calculated by dividing a company's share price by its earnings per share. The P/E ratio is a metric that can be used along with dividend yield to determine if a dividend stock is fairly valued.

Dividend income

How to evaluate dividend stocks

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.

Dividend yield

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.

What is a good dividend yield?

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.

Dividend payout ratio

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

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.

How to find high yield dividend stocks?

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.

Companies that pay high dividends

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.

  1. Imperial Brands
  2. Evraz
  3. British American Tobacco
  4. Persimmon
  5. M&G

How much do you need to invest to live from dividends?

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 Bottom Line

Dividends are a way for companies to distribute profits to shareholders, but not all companies pay dividends. Some companies decide to retain their earnings to re-invest for growth opportunities instead. If dividends are paid, a company will declare the amount of the dividend, and all holders of the stock (by the ex-date) will be paid accordingly on the subsequent payment date. Investors who receive dividends may decide to keep them as cash or reinvest them in order to accumulate more shares.

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