What are dividend stocks?

Dividend stocks can be found in a many long-term investors’ portfolios. If you’re wondering what they are, and how to use them when investing, then check out our guide to dividend stocks.

Dividend stocks: a guide

What are dividends?

A dividend is a portion of a company’s profits it can choose to return to shareholders. Not all companies choose to do this, but some do. Investors pursuing a dividend-led strategy buy dividend stocks because it they can earn money without having to be sold.

Dividends are paid in relation to how much stock an investor owns. The payment times differ from company to company, as they can be paid monthly, quarterly, semi-annually, or annually. For instance, if you had a dividend paying $1.00 per share, and you owned 100 shares, you would receive $1000 that year.

Shareholders like dividends because they show that the company is profitable and economically healthy. They also indicate that there is good potential for future earnings. In some countries, there are also tax benefits on dividends too.

Companies paying out may choose to do so for a number of reasons, usually to attract more investors, or to retain their current shareholders, but, as mentioned above, not all companies pay a dividend. They may instead choose to reinvest their profits back into the company.

How do dividends affect share prices?

Share prices are affected by dividends in a couple of different ways.

When a company announces it is going to pay dividends, then its share price may rise – particularly if it’s a surprise announcement. After a dividend has been paid, the share price may fall, usually by the same value as the dividend.

The issuing company’s share price tend to rise because investors will be excited about the dividend and may want to buy more shares before the pay so they can make more money. Alternatively, if the share price drops prior to pay out, it may be because dividend pay outs are expected to come from cash reserves, rather than profits.

A look at dividend yield

Investors may use dividend yield when deciding to invest in the best dividend stock for their strategy. This is the ratio that measures a company’s annual dividends against its share price.

If a company has stock worth £5.00, for example, and pays a dividend of 20p, the dividend yield will be 4%:

  • 20p/£5.00 = 4%

Dividend yields can grow if the company raises its dividend amount or if the share price drops. Yields can decrease if the company lowers its dividend amount or if its share price increases.

Indices are also related to dividend yields. For example, the FTSE dividend yield refers to the yield of all the dividend paying stocks listed on that index.

Compounding wealth with dividends

Compounding wealth refers to increasing the size of a holding by reinvesting the dividends. Through reinvesting dividends, the return on investment can grow through any dividends accumulated while the position is open, alongside any capital growth from the initial amount deposited.

Let’s look at an example.

You originally invested £1,000 in shares at a cost of £5 per share. You have 200 shares. The stock pays a 20p dividend per stock. At this rate, you would earn £40 per dividend on this investment in your first year.

If the share price grows £1 each year, and the dividend yield stays at 4%, you would have made £760 from dividends after ten years. The shares would be worth £2,800 (£14×200). Total ROI would have been £2560:

  • £1800 in share price growth
  • £760 from dividends

If you reinvested the money from dividends, your ROI could increase year-on-year at a higher rate than share price growth. Let’s look at an example, using the same £5 per share and 40p dividend, £1 share price growth, and 4% yield:

Share price Dividend amount Dividend paid Shares bought from dividend Total shares Investment value
After year 1 £5.00 20p per share £40 8 shares 208 £1000
After year 2 £6.00 24p per share £49.92 8 shares 216 £1040
After year 3 £7.00 28p per share £60.48 8 shares 224 £1568
After year 4 £8.00 32p per share £71.68 9 shares 232 £1856
After year 5 £9.00 36p per share £83.52 9 shares 241 £2169
After year 6 £10.00 40p per share £96.40 10 shares 250 £2500
After year 7 £11.00 44p per share £110.00 10 shares 260 £2860
After year 8 £12.00 48p per share £124.80 10 shares 270 £3240
After year 9 £13.00 52p per share £140.40 10 shares 280 £3640
After year 10 £14.00 56p per share £156.80 11 shares 291 £4074

 

In the above, you have earned 91 shares which will then pay out dividends. Total ROI would have been £3074 – £514 more than they would have received if they had taken the dividend pay out and not reinvested.

Best dividend stocks

What the best dividend stocks are will be down to your individual investment strategy and preferences. But, over the years, some companies have been identified as consistent high performers when it comes to dividend payments.

In the US, on the Nasdaq, for instance, the below have been identified as some of the best dividend stocks for long term investors:

  • Microsoft
  • Proctor & Gamble
  • Apple
  • Walmart
  • ExxonMobil

Whereas in 2020, on the FTSE 100, the following stocks paid high dividend payments to investors:

  • BAE Systems
  • Ferguson
  • Smurfit Kappa
  • Aviva
  • Sainsbury’s

Research is the key here. Take into account business performance and use fundamental and technical analysis so you’re as informed as you can be before you commit any capital. See here for our guide on how to pick stocks.