What are dividends and how do they work?

What are dividends?

Dividends are a portion of a company’s profit that it chooses to return to its shareholders. They are one of the ways a shareholder can earn money from an investment without having to sell shares. Dividends are paid according to how much stock an investor owns and can be paid monthly, quarterly, semi-annually or annually. For example, if the dividend is 50p a year and you own 100 shares, you would receive £50, that year.

Dividends are attractive incentives for shareholders, reassuring them that the company they’ve invested in is profitable and that there is a good possibility of future earnings. They are also given special tax status in many countries.

Not all companies pay dividends, some choose to reinvest profits back into the business. This is why investors who are interested in dividend payments must deliberately choose companies that offer them. If an investor did not want to trade individual stocks, they could decide to invest in a dividend-paying exchange traded fund (ETF), which holds many different stocks. This means they will only have one investment, but with more than one dividend opportunity.

There are different types of dividends that can be received. In addition to regular dividends, there are also special and preferred dividends – although these aren’t as common.

Special dividends are similar to regular dividends because they are paid on common stock. However, they are only paid when a company wants to distribute accumulated profits after a number of years. Preferred dividends are those issued to shareholders that own ‘preferred’ stock, which is stock that acts more like a bond and has a fixed dividend amount. These dividends take priority over regular dividends.

While most companies pay dividends into a shareholder’s account in cash, some choose to pay dividends in the form of property or shares instead.

Dividends are decided and administered by a company’s board of directors. However, shareholders must approve the dividend payment before it is officially confirmed via an announcement. Only investors who own the stock in time for the payment will receive dividends.

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Why do companies pay dividends?

Companies pay dividends for many different reasons, including to attract and retain investors. They can help maintain trust and favour – as certain shares could be seen as superior to a competitors’ if they pay dividends.

When a company stops paying dividends, it can be seen as a signal by investors that the business is in trouble. When it cuts the dividend amount, it could mean that the business is seeking other ways to magnify returns for shareholders in the long run. On the other hand, when a company does pay dividends, it may indicate that it does not have other avenues to generate returns, which is why it does not reinvest the capital.

One way to measure the guarantee of receiving a dividend is to check the portion of the company’s profit that goes toward the dividend, or to confirm the pay-out ratio. It may not be sustainable for a company to use a high percentage of its net income for dividend payments. This should be seen as a warning sign; the stock may be in trouble.

How do dividends affect share prices?

When dividends are announced by a company, its share price may rise if it is a surprise increase. After a dividend is paid, its share price is likely to fall by the same value as the dividend. It is also possible for competitors’ share prices to be affected by dividend payments, as investors seek larger dividends.

An issuing company’s share price will tend to rise because investors get excited about the prospect of dividends and may want to buy more shares before the pay-out. However, if the share price falls instead, it may be because the company that issues the dividend is expected to use its existing reserves to pay the shareholder.

Indices are also affected by dividend payments. That’s because indices are made up of numerous stocks, so when a constituent’s share price drops after a dividend payment, the price of the index will as well.

What is dividend yield?

Dividend yield is a ratio that measures a company’s annual dividends compared to its share price, expressed as a percentage. For example, if a company with a stock worth £5.00 is paying an annual dividend of 20p, the dividend yield is 4% (20p/£5.00). Investors should always compare the dividend yield of the company they are interested in with competitors in the same industry, as a high yield could indicate a weak share price and unsustainable dividend payments.

A dividend yield will increase if the company raises the dividend amount or if the share price drops. Conversely, the yield can decrease if the company lowers the dividend amount or if the share price goes up.

Dividends and compounding wealth

Dividends can be reinvested to increase the size of a holding, with this known as compounding wealth. The result of reinvesting dividends is that the return on investment over time is not only based on the capital growth relating to the initial amount that the investor deposited, but also on any dividends that are accumulated while the position is open.

For example, if the original investment is £1000 in shares worth £5 (200 shares), and the investor earns a 20p dividend per stock, they will earn £40 dividend on this investment in the first year. If the share price grew by £1 each year, and the dividends remained at 4%, an investor would have made £760 from dividends after ten years and own shares worth £2800 (£14 x 200 shares). The total return on investment would have been £2560 – that’s £1800 in share price growth plus £760 from dividends.

However, if they reinvested the money they earned from dividends, their investment and returns would have increased year-on-year. The increase in the investment with reinvested dividends is over and above the share price growth alone.

In this example, the reinvestment would have earned the investor 91 extra shares on which to receive dividends. The total return on investment would have been £3074, which is £514 more than they would have received had they taken the dividends in cash.

How do dividends work in the UK?

In the UK, the amount and frequency of dividends paid to investors is determined by the individual company. The dividends are paid from profits, but some companies make dividend payments from their retained earnings even if they don’t make a profit – this is to maintain favour with shareholders. The only requirement before paying dividends in the UK is that the company must first pay all regular taxes and expenses.

There are two payment dates, depending on the dividend. Final dividends are paid annually, at the end of the financial year, while interim dividends are paid throughout the year – monthly, quarterly or semi-annually.

The company does not have to pay tax on the dividend payments it issues, but the shareholder receiving the dividend may have to pay tax on the amount received. An investor in the UK may receive up to £2000 in dividends before they have to pay income tax on the imbursement.¹

Important dates for dividends

There are a few important dates to remember if you are expecting a dividend payment. These include:

1. The dividend announcement date, which is the date at which the company’s management team announces the details of the upcoming dividend payment
2. The ex-dividend date, also known as the ex-date, which is the date by which an investor must own shares to qualify to receive dividend payments
3. The record date, which is the cut-off day for the company paying the dividend to decide which shareholders qualify to receive it
4. The dividend payment date, which is the day on which the dividend payment is made to shareholders

Dividends when trading

Dividends are not paid when trading, but holders still benefit from them. This is because trading is carried out using derivative products, which take their price from the underlying market. Derivative products do not require traders to own the underlying asset to open a position, which means that a trader will not gain any shareholder rights, such as voting abilities or dividends.

Although dividends can affect share prices, they will have no material effect on a trader’s open positions with IG. That’s because positions are adjusted based on the dividend amount and position size. If the trader holds a short position, and the share price goes down after a dividend payment, IG will debit the account to bring the trader’s position in line with the new price. If the trader holds a long position when this happens, IG will credit the account to make sure the trader does not run any losses due to the dividend payment.

The important thing to remember is that whether a trader is long or short on the stock, they will not materially be gaining or losing when dividends are paid to shareholders and a dividend adjustment is made.

Find out more about dividend adjustments

If you want to trade shares instead, you can create a trading account. Alternatively, you can practise and improve your skills using a demo account.

Dividends summed up

• Dividends are a portion of a company’s profit that it chooses to return to its shareholders
• There are different reasons why a company may choose to pay dividends including to attract and retain investors
• When dividends are paid, it’s common for share prices to fall because the company uses its own profits to pay them
• Shareholders can reinvest the dividends received and benefit from compounding wealth
• To start tradding shares, open an IG trading account today

¹Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.