What is a Share Dividend?

When a company makes a profit it has a number of options what to do with that profit. One of those is to pay out some of its profits to its shareholders as a way to reward them for their investment. Such a payment is called a dividend, and is usually made either quarterly, half yearly, or annually.

When a company pays a dividend, it does so from profits produced in the year the dividend is made or from profits retained on its balance sheet from previous years. This means that the value of the company effectively reduces by the total dividends paid out, and the share price is likely to fall by the amount of the dividend when it is paid.

What companies pay dividends?

Whilst all companies are able to pay a dividend newer companies are less likely to do so, preferring instead to use all profits to fuel growth or product development. Such companies are targeted by investors looking for capital growth.

On the other hand, larger, more mature companies – particularly those in cash generative sectors such as utilities (electricity, gas, and water) – see less need to retain profits and pay dividends instead. Income seeking investors are likely to buy shares in this type of company.

Are dividends only good for investors wanting income?

While dividends can produce a good and lasting stream of passive income for investors, one commonly used investment strategy for those not wanting income immediately, but with a need for income in the future, is to reinvest the dividends.

The effect of dividend reinvestment is similar to letting interest build up in a cash savings account: the interest earned attracts interest, which then helps the value of the savings grow accordingly.

How dividends are paid

When a company announces a dividend, it does so on the dividend declaration date. Once that announcement has been made, the company is committed to paying that dividend.

Along with the dividend declaration, the company will also announce a record date, which is the day on which it will look at its shareholder register. It is these shareholders who receive the dividend payment. This date is more commonly known as the ex-dividend date, for anyone who buys shares on this date or beyond will be doing so with the announced dividend excluded.

The ex-dividend date is usually four days before the payment date, when cash dividends will be given to the shareholders entitled to them.

Taking the dividend

Assuming an investor buys £10,000 worth of shares and those shares pay a dividend of 3.5% annually, and the value of the shares grows by 5% each year. After 20 years the investor would have seen the value of his investment increase to £26,533 and his dividends increase from £350 in the first year to £929.

Over the course of his investment the investor would have received a total of over £12,152 in dividends

Reinvesting the dividend

If, instead of taking the dividend each year, the investor reinvested his dividends back into the company paying them, then given the same assumptions used in the above example, the value of the investor’s shares will have risen to £51,120. That’s nearly double the value of the shares held when taking the dividend each year.

And the dividend the investor would be receiving after twenty years would be £1789 annually.

As the chart below shows, reinvestment of dividends produces exponential growth: the value of the investment grows faster the longer that the dividends are reinvested. Doubling investment value takes around 9 years in the above scenario, whilst quadrupling value takes just 17 years.

share-dividend

If the share price falls during the term of the investment, then providing the actual amount of the dividend remains unchanged or even increases, the dividends paid will buy more shares at a lower price. These extra shares attract future dividends, and when the share price has recovered the total dividend income received will be greater because of the shares bought when the share price was depressed.

A dividend reinvestment strategy benefits most by the length of time the investor remains invested and reinvesting. The first few years sees a minimal effect, but the longer the strategy is in place and the shares held, the greater the likely rate of increase in investment value and potential future income.

In summary

Dividend paying stocks can be used to produce income now or in the future, and by reinvesting dividends an investor can use dividend stocks for the purposes of growing his capital.

There are four main elements for dividend investors to remember:

  • Money paid out in dividends and then reinvested will attract future dividends, compounding growth over a period of investment. It is this that creates exponential growth.
  • In order to produce greater future income, reinvestment of dividends should always be considered when the dividend is not needed. Investors who take the dividend are likely to spend it.
  • Reinvestment of dividends when the stock price is low buys greater numbers of shares on which future dividends will be earned. This creates greater income potential when it is required in the future.
  • Dividends are subject to tax. When finally taking the dividends, an investor will be liable to paying income tax on the dividend income depending upon his individual tax position at the time. For this reason, a dividend reinvestment strategy should always be sheltered within a tax efficient investment vehicle, such as an ISA, whenever possible.
Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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