Dividend investing: the complete guide

Dividend investing is an investment strategy that has two distinctive methods: regular dividend payments from companies you own stock in; and the capital/share price growth of those stocks over time.

Dividends are paid on a, yearly, bi-annually, quarterly, or even monthly basis. The "dividends per share" value combined with the number of shares purchased determines the income you receive from each payment.

In recent years, high-street banks interest rates have hit rock bottom, with many offering just 0.5% on many account types. This combined with a high inflation rate in the UK makes inflation beating capital growth through a high-street bank a thing of the past (for the time being). Poorly performing savings accounts have drawn more people towards the idea of utilising dividend payments as a form of income/capital growth instead.

Dividend companies pay a portion of their profit back to their investors (in the form of dividend payments) as a reward to shareholders for continuing to hold their stock. The main aim of publicly listed companies is to deliver shareholder value, and this is one of the ways they can do this.

How much a company will pay is determined by the board of directors, who will consider the previous year’s profit and losses, and then come to a decision on what amount they can afford to pay out to the shareholders and what must be reinvested. Some firms choose to pay very low dividends to their shareholders to be able to retain most of their profit and concentrate on the growth of the company, whereas others choose to pay a higher dividend to encourage more investors as they may be in slow growth industries, such as consumer staples or real estate.

The second way companies deliver shareholder value is via capital or share price growth, they do this by improving business metrics such as market share, revenue, or profit, which then in turn makes the company more attractive to investors, consequently boosting the share price.

And the third way companies deliver value back to their shareholders is via share buy backs, which is akin to a dividend but instead of a pay-out per share the company uses their profit to buy back shares in the open market, which reduces the supply of shares, in turn boosting the stock price for the existing shareholders.

There are numerous benefits to investing in dividend paying stocks, here are just a few of the main points to consider:

Whilst there are plenty of positives of investing in dividend paying stocks, there are also a few drawbacks, such as:

Some of the most important factors when investing in dividend shares are the following:

The dividend yield is a calculation of the value of the dividends a company pays out each year in relation to its stock price. This figure is represented as a percentage and is a simple calculation of the annual dividends paid out by the company, divided by its price per share. As a result of this calculation, a stock’s dividend yield increases as the value of its shares decrease and lowers when the share price increases. Therefore, it is common to see large cap, continuously expanding companies offering low dividend yields.

When searching for dividend paying stocks, investors will often choose stable and reliable companies, which often comes down to finding companies that have a good history of paying their shareholders dividends on a consistent basis.

They may also look to see if they have raised their dividend payments to their investors for several years running. This shows that the companies are in no immediate financial difficulty or have any issues within the business that requires them to “cut” their dividend, something that occurs when a company decides it cannot pay the dividend to their shareholders on the date offered and must instead be re-invested back into the company.

A company’s payout ratio can be used to quickly assess how much of their turnover is being reinvested into the company and how much of it is being paid out to shareholders. For example, if a company have a payout ratio of 10%, you know that it is re-investing 90% of its yearly capital gains.

The declaration date is when a company’s board of directors announce what the next dividend amount will be. On this date the board of directors will also make the ex-dividend date clear, and the date the dividend will be paid to shareholders. Taking the amount of the dividend, the dates of payment and exclusion into account plays a big part in an investor’s decision as to whether purchasing a stock is a good investment or not.

The ex-dividend date is simply the date that determines whether an investor is entitled to the next dividend payment. For example, if a company sets the ex-dividend date for 12th August and an investor buys 200 shares of the company before that date, they will be entitled to the next month’s dividend with the value of the purchased shares included within it. However, if they invest after the ex-div date, they would not be entitled to that month’s dividend payment.

The payment date is when the dividend is paid into the investors brokerage account or cheques are issued. This date can be up to one month after the ex-dividend date, but is usually paid within two to three weeks, and will consider the number of shares you held in the company before the ex-dividend date passed. The shareholders have the option to take the dividend as a payment directly into their brokerage account, or they can opt to use the value of the dividend to purchase more shares from the company. This is known as a dividend reinvestment plan or “drip” account, which we will explain in greater detail later.

The EPS (earnings per share) of a company is calculated by dividing the net income of that company by the average number of outstanding shares it provides. This figure is often reported each quarter when the earnings report of a company is disclosed. A profitable quarter will show a positive EPS, and for a non-profitable quarter, it would show a negative EPS. The number of shares a company holds can change throughout the year, so figures from the first quarter of the year can differ greatly from the next if they’re done a stock split/buyback or issued new shares. For this reason, a more accurate way of determining a company’s EPS is to average out the number of shares a company has over a longer time.

For example, if a company has 2 million shares available, with a net income of £10,000,000, it will have an EPS of £5 per share.

An important aspect of a company’s EPS for long-term dividend investors to consider is its historical trend. To receive reliable income from dividends, a company should be highly profitable each year, which should prevent it from needing to cut dividends. If you can see that the EPS of a company over the past 5 years has been steadily increasing each quarter, you can see it has a good level of stability and profitability, which could make it a more reliable source of dividend payments.

A word of caution on EPS

EPS values can be easily manipulated by using a method of accounting called “accrual accounting”, which allows profits to be calculated without the actual amount having been paid to the company. This is also true for expenses that are yet to be paid, which are easily written off as having already been dealt with. This is a way of artificially increasing the price of the stock by inflating the EPS. As a result of this, EPS should not be used on its own as a measure of a company’s value or success, but should be considered with multiple other factors, such as the company’s overall cash flow (as this will uncover if any creative accounting has occurred), along with those outlined above.

It is important to compare one companies’ EPS against a company of similar size in the same industry, if the EPS of the company you are interested in is vastly higher than others, it may be worthwhile investigating how the stock has achieved this and why they are outperforming the rest of the industry.

Checking the income statement and evaluating gross, operating, and net margins can help you assess whether you think the EPS the company is stating is realistic or may have been manipulated.

A company’s net income is the total value of all its revenue for the year, minus expenses.

The net income is valuable information to an investor, as it can quickly show how profitable they currently are. For example, they may state the business has generated over £2m gross income over the past 12 months, which would initially sound impressive. However, if they had running costs and additional expenses of £1.5m for that year, we are left with a net income of only £500,000, which is substantially less impressive than the first figure.

For the financial year 2021-2022 in the UK, dividends are tax-free for the first £2,000 earned, and any income generated after this amount is subject to the same rate of taxation as your income tax band.

A dividend reinvestment plan (DRIP) is an option that some brokers offer to their clients that allow them to automatically reinvest the value of the dividends paid to them by purchasing additional shares of the same stock.

For instance, if you were to have a DRIP account set up with a broker and they paid out a monthly dividend of £30, instead of that payment being allocated as cash into your brokerage account, it would be used to purchase additional shares within the same company.

Compound interest​ is described as “interest on interest”, and it can be highly beneficial to investors, as they can use the capital gained from dividend payments to purchase additional shares within the same company, meaning that the next time they get paid their dividend, it gets paid for the now larger stock holding, the cycle repeats and the compounding effect grows exponentially over time.

Compounding is seen as an important aspect of investing for retirement, as the younger you start, the easier it is to amass a large enough potential fund to live off. For example, a person who starts saving £200 a month in their early twenties until they are in their fifties has the potential to be able to happily live off the dividends from the consistent payments they made earlier in life (if the market remains favourable).

A person who starts much later in life, will not have had the full effects of compounding to speed up the saving process and will need to invest a much larger sum in a shorter period of time to gain the same value of dividend payments.

Stocks purchased through a DRIP account are usually either free of commission or come with very small fees. This offers a clear advantage to the investor, because when purchasing shares on a regular basis, commissions charges can quickly eat into profits. This makes purchasing additional shares of a stock more convenient and cost effective for the investor.

Instead of requiring an investor to buy one complete share of a company’s stock, a fractional share allows you to buy a portion of it. This is a highly efficient way of purchasing shares, as the additional value of each portion of a share is taken into account when the companies calculate your dividend payments.

Dividend investments are often considered to be a safe investment, and whilst there are certainly less risks associated with this type of investing in comparison to growth investing or day trading, there are still some risks that need to be taken into consideration.

Dividends are not safe from unstable markets. If the company you have invested in comes into financial difficulty, runs into unforeseen expenses, finds a growth opportunity it wants to fund or any other reason, they can suspend the dividend to a later point, or cut it entirely.

For an investor that has purchased dividend paying stocks for their reliable income, these events can be frustrating. Every missed or cut dividend is a lost opportunity for reinvestment, which slows the growth rate of the income portfolio​ further.

A well-diversified portfolio may help counter the negative effects of a dividend cut/suspension from a single stock. However, in times such as the 2008-2009 market crash, several large companies cut their dividends across multiple market sectors, causing great disruption to dividend investors.

Whilst dividend investing may be a popular way to potentially generate income via the stock market, there are many factors to consider when deciding which dividend stocks to purchase. Due diligence is vital to ensure that you don’t invest money into a company that may initially look profitable but could have serious underlying issues when investigated more closely.

There are a few simple but important aspects to consider during the research phase when considering purchasing dividend paying stocks.

Living off dividend payments is possible, but it can take many years to accrue a portfolio with enough value that pays large enough dividends to replace the income that can be gained from employment. However, if investing is consistent and started early enough, it is possible to live off dividends.