What are dividends and why are they important?

what are dividends

In a world of ultra-low interest rates, dividends have received an increasing amount of attention in recent years. So what exactly are dividends?

What are dividends?

A dividend is essentially a portion of a company’s profits that is paid out to the owners of the company ie. the shareholders.

When a company makes a profit, it has to do something with the money. Most of the time, the company will either choose to reinvest the money, or instead, reward its shareholders with a share of the profits.

Fast-growing companies will often choose to reinvest the profits in the pursuit of further growth. However, more established, mature companies will often decide that the best course of action is returning some of the profits to shareholders via a dividend payment.

Calculating the dividend ‘yield’

A dividend can be expressed in terms of the dividend payout ie. 20p per share, or as a ‘yield.’ The yield is easy to calculate and is simply the dividend payout per share divided by the share price, expressed as a percentage. For example, if a company’s dividend payout is 20p and its share price is 400p, then its yield is 5%, calculated by dividing 20p by 400p and expressing the result as a percentage.

Among dividend paying companies, dividend yields will vary. Some companies pay lower yields of around 1%-2%, preferring to reinvest most of their profits, while others pay more generous dividends in the 3%-5% region. Some companies even have yields higher than this, but this is where the dividend investor needs to exercise caution, as a really high yield can signal that the dividend is about to be cut.

When are dividends paid?

Most UK dividend paying companies make payments to their shareholders twice a year. Many of these companies pay a smaller ‘interim’ dividend and then a larger ‘final’ dividend. The payout dates vary from company to company but are easily found on the internet.

Why are dividends important?

While a 3%-5% yield may not seem like much now, dividends have been shown to make up a significant proportion of long-term total returns from the stock market. Reinvesting dividends year after year over a long-term investment horizon can produce amazing results, simply due to the power of compounding.

The tangible nature of dividends also provides stability during bear markets and periods of market volatility. No matter whether the market is rising or falling, the dividend investor always receives regular cash payments, which can either be spent or reinvested. In contrast, with non-dividend paying growth stocks, the investor is relying on other investors to someday buy their shares for a higher price than they paid, and that, in my view, is more of a risk.

I take a more detailed look at the benefits of dividends here.

This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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