How dividends work: A comprehensive guide to dividend investing

How to evaluate dividends

Evaluating dividends is not just about looking at the amount paid. There are several metrics investors can use to assess the value and sustainability of dividend payments.

Dividend yield

The dividend yield shows the annual dividend as a percentage of the company's current share price. It clearly indicates how much return investors can expect relative to their investment. For example, if a stock pays $4 annually and its current price is $100, the dividend yield is 4%.

Dividend payout ratio

The dividend payout ratio measures the portion of a company's earnings paid out as dividends. A high payout ratio may suggest that the company isn't reinvesting enough into its operations, while a lower ratio could indicate room for future dividend growth.

Dividend history

A company's dividend history is another important factor. Consistent or growing dividends over time reflect a company's financial stability and commitment to rewarding its shareholders. A long track record of stable dividends often signals a robust and reliable business model.

How dividends work

To fully understand how dividends work, it's vital to grasp the entire process and the critical elements involved:

Key dividend dates

Several important dates define when a dividend is paid and who is eligible to receive it. Understanding these dates ensures investors know when and how they can expect dividends.

Declaration date

The declaration date is the day the company's board of directors announces the dividend. This includes the dividend amount, the payment schedule, and other essential information such as the ex-dividend date and record date.

Ex-dividend date

The ex-dividend date is critical for determining who qualifies for the dividend. If you purchase the stock on or after this date, you will not be eligible for the upcoming payment. Only those who own the stock before the ex-dividend date are entitled to receive the dividend.

It's also common for the stock price to drop slightly on this date, reflecting the value of the dividend that is about to be paid out.

Record date

The record date is when the company reviews its list of shareholders to determine who is eligible to receive the dividend. If you owned the stock before the ex-dividend date, your name will be recorded, and you'll receive the payment.

Payment date

The payment date is when the dividend is officially paid out to shareholders. Cash dividends are credited to shareholder accounts, while stock dividends result in additional shares being allocated to each shareholder's account.

Types of dividends

Dividends can come in different forms, each with its own benefits and considerations:

• Cash dividends. These are the most common type of dividends, paid in cash to shareholders. Investors can choose to reinvest these dividends or take them as income.
• Stock dividends. In this case, dividends are paid in the form of additional shares. This allows shareholders to increase their holdings in the company without having to buy more stock.
• Special dividends. Occasionally, companies issue special dividends, which are one-time payouts often made when the company has excess cash. These are not part of the regular dividend schedule but can offer an extra return to shareholders.
• Dividend Reinvestment Plans (DRIPs). Many companies and brokers offer dividend reinvestment plans, allowing shareholders to automatically reinvest their dividends into more shares of the company. This strategy can help compound returns over time.

How dividends affect share prices

The announcement of a dividend can influence a company's stock price. On the ex-dividend date, the stock price typically drops by the amount of the dividend.

For example, if a stock trades at USD 50 and the company announces a USD 2 dividend, the stock price may adjust to around USD 48 on the ex-dividend date. This reflects that new buyers will not receive the dividend and thus are paying for the stock minus its upcoming payout.

Frequency of dividend payments

Dividends are commonly paid quarterly, though some companies may distribute them monthly or annually. The schedule depends on the company's policies, with many large corporations opting for regular quarterly payments to maintain investor confidence.

Mutual funds and exchange-traded funds (ETFs) that pay dividends follow a similar schedule based on the returns generated by their holdings.

How reinvesting dividends works

Instead of taking cash payments, some investors choose to reinvest their dividends. Dividend reinvestment plans (DRIPs) allow shareholders to automatically purchase more shares of the company using the dividends they receive.

This helps investors grow their ownership over time without contributing additional funds. Reinvesting dividends can have a compounding effect, especially for long-term investors, as both the number of shares and future dividend payments increase.

How ETF dividends work

Dividend-paying ETFs distribute dividends based on the performance of the stocks within the fund. Similar to individual stocks, ETFs have ex-dividend dates, record dates, and payment dates. Investors in these funds receive dividends that reflect the combined dividends of the ETF's underlying holdings.

Many ETFs also allow for dividend reinvestment, making them an attractive option for investors seeking both growth and income.

Dividend example

Let's look at a practical example of how dividends work in real-world investing:

Imagine you own 100 shares of a company that has declared an annual dividend of USD 4 per share. This means you will receive USD 4 for every share you own. With 100 shares, your total annual dividend income from this company will be USD 400.

If the company pays its dividends quarterly, you will receive USD 1 per share each quarter. In this case, you would earn USD 100 every three months, totalling USD 400 annually.

Which types of companies pay dividends?

Not all companies pay dividends, and the decision to do so often depends on the company's financial health, maturity, and long-term strategy. Companies that consistently generate stable profits are more likely to distribute dividends to shareholders, as it reflects their ability to share the wealth they generate.

Established and profitable companies

Larger, well-established companies with a track record of steady earnings are the most common dividend payers. These companies are often leaders in mature industries such as utilities, consumer goods, pharmaceuticals, and financial services.

Since they have reached a level of stability and may have fewer opportunities for aggressive growth, they distribute a portion of their profits to shareholders as dividends.

Companies in stable industries

Industries that experience less volatility, such as utilities and telecommunications, are known for regular dividend payments. These businesses often generate predictable cash flows, making it easier for them to commit to consistent dividends.

Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs)

By law, REITs and MLPs are required to distribute a significant portion of their income to shareholders in the form of dividends. These companies are popular among income-focused investors because they offer higher-than-average dividend yields than traditional stocks.

How to invest in dividend stocks

Investing in dividend stocks provides a way to generate regular income while growing a portfolio over time. However, choosing the right dividend stocks requires a careful approach that balances potential income with long-term sustainability.

1. Prioritise dividend stability over yield

While high dividend yields may seem appealing, stable dividends are often a better indicator of a company's health. Companies with a history of paying consistent or increasing dividends signal financial resilience. Dividend aristocrats—companies with a long track record of raising dividends—are often considered a reliable choice for income-focused investors.

2. Evaluate the company's financial health

Dividend payments are only sustainable if the company's underlying finances are strong. Factors such as cash flow, profit margins, and debt levels should be assessed to help you evaluate that the company can maintain its dividend payments even during economic downturns.

A company with a solid balance sheet and consistent earnings growth is more likely to continue rewarding shareholders with dividends.

3. Reinvest dividends for compounding growth

Reinvesting dividends through dividend reinvestment plans (DRIPs) allows shareholders to purchase additional shares automatically, helping to compound returns over time. This strategy can be especially effective for long-term investors who want to grow their portfolios without making further cash contributions.

4. Diversify your dividend investments

A well-balanced portfolio includes dividend stocks from multiple sectors. Companies in industries such as utilities, consumer staples, healthcare, and financials are known for paying regular dividends. Diversifying across these industries can help reduce the risk of relying too heavily on one sector, especially during periods of market volatility.

5. Consider dividend ETFs for simplicity

For those looking for a more hands-off approach, dividend-focused ETFs offer broad exposure to dividend-paying companies across various sectors. These funds simplify the investment process by pooling a selection of companies that pay dividends, providing regular income while reducing the need for extensive individual stock research.

6. Monitor your dividend growth

Stocks consistently growing their dividends often reflect stronger financial health and long-term potential. A company that can increase its dividends regularly shows that it is not only generating profits but is also committed to sharing those profits with shareholders. Tracking dividend growth is a crucial metric for identifying companies with solid future prospects.

Conclusion: Building wealth through smart dividend choices

Dividend investing can allow investors to achieve steady income and long-term growth. Companies with solid financials and a reliable history of dividend payments provide the foundation for this strategy. Stability and diversification across sectors also help you ensure that the portfolio grows while withstanding market fluctuations.

A well-balanced dividend portfolio has the potential to not only generate consistent income but also support broader financial goals, even in uncertain economic conditions. Remember to check dividend history and the financial performance of the company when selecting income generating stocks.