What is dividend investing?

What is dividend investing?

Dividend investing is the process of investing in the shares of companies that pay out a regular dividend to their shareholders. Dividends are regular sums paid out based on a company's income and are calculated as a yield return.

Not all companies pay out a dividend, so those that do – and provide high yields and the potential for share price growth – are popular among investors. However, these can be difficult to find. A dividend yield is calculated as a percentage of the share's price.

Dividend growth investing can offer strong returns when used as part of a wider investing strategy. But remember – past performance can't be used to guarantee future returns.

Dividend payments are also not legally required of a company. This means it's never a certainty that a company will pay out a dividend, even if it has a strong track record of doing so. A company's ability to pay a dividend can be affected by several internal and external factors, like its profitability in the year prior to an expected payment, its own investment plans and the wider availability of funds.

Why reinvesting dividends is key to long-term returns

There are two key ways to make money from investing in shares. The first depends on the capital returns from share price appreciation. This is the most popular way for investors to try to make money. The second comes from income returns when companies pay out dividends.

A way to maximise returns from the latter is by reinvesting those dividends back into the company. This creates the potential for a compounding effect. When dividends are reinvested, they are used to purchase additional shares of the same stock. In turn, this increases the potential for future dividend payments.

Compounding dividends can significantly enhance your investment returns over the long term. By reinvesting the dividends, you are essentially earning returns on your initial investment as well as on the reinvested dividends. This compounding effect allows your investment to grow faster than if you were to take the dividends as cash and rely only on share price growth for more returns.

Suppose you have invested £10,000 in a stock that pays an annual dividend yield of 5%. In the first year, you would receive £500 in dividends (£10,000 x 0.05). Instead of withdrawing this £500, you decide to reinvest it by purchasing more shares of the same stock.

Let's assume the stock's price is £50 per share; therefore, you can buy 10 additional shares (£500 / £50). Now, you own a total of 210 shares in the company, instead of your original 200 shares based on the initial £10,000 investment.

In the second year, the stock price increases to £55 per share, and the company maintains the same 5% dividend yield. As a result, you would receive £577.50 in dividends (£11,550 x 0.05). Again, you choose to reinvest this amount by purchasing additional shares, which would be approximately 10.50 shares (£577.50 / £55). Now, you own around 220.50 shares.

This process continues year after year, with your dividend payments being reinvested and buying more shares. Over time, the compounding effect starts to accelerate, and your investment grows exponentially.

Advantages of dividend investing

• Can increase returns from stock investing

Dividends can add a premium to the classic approach of investing in shares. For example, 75% of the returns from the S&P 500 from 1980 to 2019 came from dividends.

• Provides extra metrics for fundamental analysis

An investor using fundamental analysis uses many company metrics to make a decision on a stock's value. Dividends give an extra indicator because they can demonstrate a firm's cash flow over time, an important factor in ensuring they aren't indebted.

• Reduces overall portfolio risk

Dividend stocks can be less volatile than other stocks, thanks to their fairly consistent demand and the offsetting of dividend payments when their price contracts. This means an investor can balance it out against riskier, non-dividend-paying stocks that might offer higher share price appreciation.

• Tax advantages

Dividends may be taxed at a lower rate than other forms of investment income, depending on an investor's tax bracket.*

• Can help an investment keep pace with inflation

Inflation is one of the key comparative metrics an investor looks towards to make sure their investment is making money. If a dividend stock grows at a slower pace than inflation, the investor is increasing the value of their holding.

For example, say inflation grows at 3% but your investment grows at 2%. Your investment is now worth less. In reverse, imagine your investment grew at 2% but also offered a 3% dividend yield. It has now outpaced inflation, and your purchasing power has grown.

Research shows dividend stocks tend to rise when inflation does, offering a buffer against the adverse effects of rising prices.

• Even during periods of recession, dividend stocks have historically shown growth

It can be important to hold onto dividend stocks to safeguard against the impacts of a recession. While recessions typically hurt stocks, those that pay dividends have generally been less impacted in the past.

This is in part thanks to the sectors that typically pay dividends, like energy and utilities, being more recession-proof. It's also because investors flock to dividend payers for more secure income.

Disadvantages of dividend investing

• It's a long-term investment

Because dividends are effective when reinvested for compounding, it can take years for an investor to enjoy noticeable returns from this strategy. Dividend investing usually requires patience, so it's not seen as an effective strategy for a short-term approach or day trading.

• Can be less profitable

Dividend stocks typically don't see their share price appreciate as quickly as non-dividend-paying stocks, including those in the same industry. That can be because growth stocks are often more popular during a bull run, while dividend-paying companies may lose out from not investing those dividends in innovation instead. This leaves an investor susceptible to missing out on larger share price gains evident in growth stocks, which might outweigh returns from dividends.

• It may not produce more than 10% annually (similar to long-term)

Even with the boost of a dividend yield, dividend stocks don't tend to produce more than 10% growth annually. Over the long run, investors may be surrendering higher returns for the security of a dividend payment.

Companies that don't offer dividends are often reinvesting in the company's growth instead, which can offer higher returns over time relative to dividend stocks.

• Dividend payments are not legally required

Because dividends are not a legal requirement for companies, it means they can choose to stop paying them out at any time. This increases insecurity from a dividend investing strategy. However, most major companies avoid getting rid of dividends due to their attractiveness to investors.

How to research stocks for dividend investing

Dividend investing requires plenty of research to ensure you are well informed about your stock picks, particularly in regard to a company's profitability and its potential to consistently deliver dividends over time.

Check to see if the company has demonstrated long-term profitability

When vetting dividend-paying companies, long-term profitability is a key consideration. Although any company can occasionally experience a profitable quarter, those that have demonstrated consistent growth on an annual basis might be more likely to consistently pay out future dividends.

Find companies with healthy cash flow generation

Most dividend payments come from a company's positive cash flow. You can calculate a company's free cash flow to equity to determine a suitable investment.

Avoid companies with high debt

Stocks that have high debt are more likely to struggle with achieving the liquidity necessary to consistently pay out dividends because of the need to re-service their debt. The uncertainty of interest rate changes also adds to the risk that dividends might not pay out consistently.

Check sector trends

While an investor might lean on certain sectors known for paying dividends, this alone shouldn't act as a strategy for picking stocks. For example, energy stocks are known for their regular dividend payouts. But if wholesale oil prices fall, this hits the profits of those companies as supply outweighs demand. This can weigh on cash flow and, accordingly, companies' abilities to pay out dividends.

When and how to receive your dividend payments

Companies typically pay out dividends on a quarterly or bi-annual basis. It is usually declared alongside their financial results, with a date for payment set in the near future. Companies will often give an outlook for annual dividends alongside this announcement.

If you want to receive a dividend payment from a stock, you need to do so before its 'ex-dividend' date. On or after this date, an investor won't receive a dividend from investing in the stock.

You can then choose whether to receive this dividend directly as a cash payment into your account or to reinvest it.

Dividend reinvestment plans (DRIPs) enable reinvesting of any dividends for compound returns over time. When you trade with us, your dividend won't be automatically reinvested, but you can choose to reinvest the dividend you receive back into the company.

Investors can also choose their preferred method of receiving dividends through their brokerage account or by contacting the company's investor relations department. If you opt to automatically reinvest dividends with a broker, it usually comes with a charge.

Common pitfalls to avoid in dividend investing

Dividend investing can have several pitfalls. These are the main ones you should look out for:

• Paying high commission fees

Frequent contributions can lead to high transaction costs when investing in dividend stocks. If an investor pays significant commissions for every investment, it can eat into the overall returns, especially when dealing with small dividend amounts.

• Not accumulating enough dividend income to reinvest consistently

While compounding is a popular dividend investing strategy, if an investor does not accumulate enough dividend income to purchase additional shares, the benefits of compounding can be limited.

• Making sure you are aware of UK tax laws

Dividends received from investments held in non-retirement accounts are generally subject to taxes. In the UK, you are taxed on any dividends that exceed your personal income threshold. The tax rate increases as your dividend income increases. Some investors may overlook or underestimate the tax implications of dividend income, potentially resulting in unexpected tax obligations.*

• Chasing high dividend yields for quicker earnings

It's important to not only focus on a stock's dividend yield when investing. Companies that pay higher yields may be more financially strained, putting them at risk of consistently paying that rate out. It's crucial to evaluate the sustainability and growth potential of a company's dividends, along with other fundamental factors, to make sound investment decisions.

Types of dividends

• Cash dividends: when a company pays its shareholders in cash payments (typically quarterly but can be an annual payment)
• Stock dividends: when a company rewards a shareholder by increasing the number of shares the said investor owns. These are not taxed until a shareholder sells them, so they can be quite attractive to investors*
• Scrip dividends: when a company can't afford to pay dividends at that current time, they will use a scrip. This is essentially a promissory note to say that they will pay the dividends at a future date (sometimes these can include interest)
• Property dividends: though rare, some companies can pay dividends in the form of assets or inventory to shareholders
• Liquidation dividends: the type of dividend paid to shareholders during a partial or full liquidation

How to invest in dividend stocks

You can invest in dividends with us using the following steps:

1. Create your live account or practise on a free demo account
2. Choose our Smart Portfolios, which are managed for you, or share dealing if you prefer a hands-on approach
3. If you choose share dealing, make sure you do further research on how to diversify your portfolio and manage your risk
4. If you choose one of our Smart Portfolios, we'll ask you some questions about your risk tolerance
5. Invest a lump sum and/or set up a regular instalment to fund your account

If you have a Smart Portfolio with us, we will automatically reinvest any dividends paid. The cash is paid into your account, after which we then allocate it back into your portfolio.

You can receive a dividend using our share dealing account as a payout, which you can then manually reinvest into your investment account.

As soon as we receive dividend payments for any of the shares you own, we will credit your account with the amount you are eligible for. This usually occurs within one day of the dividend payment date.

Dividend investing summed-up

• Dividend investing is the process of investing in stocks that pay out a dividend
• An effective way to make gains from dividend investing is to reinvest dividends back into the company to compound returns over time
• Before investing in a dividend-paying stock, you should check its history of profitability and cash flow, and avoid stocks with high debt
• To receive dividends in a company, you need to invest in it before its 'ex-dividend' date
• There are several types of dividends you can receive, including cash, stock and scrip dividends

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