Stock dividends are often considered a good potential option for those interested in making long-term gains, and investing in stocks that pay dividends could be one of the most important investment decisions you make. To know whether dividends are the right fit for you, it’s important that you first learn what they are, how they work and how to develop a dividend investing strategy.
When you buy a share, you become a joint owner of a company. This means that you are entitled to a share of the profits, which are paid out as dividends. Dividends form a passive income stream that can either help to support your lifestyle or be reinvested. Knowing how to best manage stock dividends is a good opportunity to work towards achieving financial independence.
What are dividends?
Dividends are payments made by limited companies to shareholders. These payments can be in the form of cash or an alternative incentive, such as additional shares. Dividends are paid out to shareholders on a pro-rata basis — the more shares you own, the greater the total amount of dividends you will receive.
How do stock dividends work?
The management of a company decides the amount and frequency of dividend payments. They also determine how much of the firm’s available capital is held back to support business operations and how much is distributed to shareholders.
Most companies that pay dividends do so on a quarterly, half-yearly or annual basis. The size of a dividend pay-out is often seen as an indicator of the firm’s performance and future prospects.
The process of adding dividends to an investor’s account is managed by the company in question, and the chosen broker. Investors are unlikely to be required to take any action, except perhaps deciding to receive the dividend as cash or additional stock.
Tip: If a firm is regarded as a good investment stock, and announces a lower-than-usual dividend, it is typically seen as bad news and can often result in a fall in the company’s share price.
Investing in dividend stocks
Many dividend stocks share certain characteristics, including solid business models, reliable income streams and potentially limited growth prospects. Instead of holding capital back to invest in new projects, cash is distributed to investors. This means that the company has a lower chance of posting a capital gain and seeing a rise in its stock price.
The stocks of companies that have more dynamic business plans may not pay a dividend. Investors in these growth stocks buy them with the expectation that the share price will rise if those plans come to fruition.
“Dividends are paid out to shareholders on a pro-rata basis — the more shares you own, the greater the total amount of dividends you will receive.”
Types of dividend investment
There is room for dividend stocks in most investors’ portfolios. Those with lower risk profiles, or retirees, might be interested in dividend stocks for the passive income that they bring. Others, with more aggressive strategies, might buy dividend stocks to balance out higher risk assets, as part of building a well-diversified portfolio or to increase the compounding effect.
Top dividend stocks
Some companies have developed a reputation for regularly paying higher-than-average dividends. Using dividend yield as a guide, it’s possible to find the top dividend stocks, such as Verizon Communications Inc. (VZ), AT&T Inc. (T) and Bank of America (BAC), which had dividend yields of between 3% and 7% in 2023. These stocks compare well to the long-term average dividend yield of the S&P 500 Index, for example, which is 2.00%.
How does tax on dividends work?
Dividend tax is determined by your location and other aspects of your personal circumstances. In the UK, dividends are liable to taxation. The dividend tax rate for basic rate taxpayers is 8.75%, but all UK residents have a dividend tax allowance of £2,000, meaning the first £2,000 of dividend income is tax-free. Dividend tax rates vary by country, so it’s important to research this thoroughly before investing in dividend stocks.
Tip: Government-backed investment schemes, such as ISAs (Individual Savings Accounts), allow you to protect your dividend income from taxation. UK residents do not pay tax on dividends from shares held in an ISA.
Developing a dividend investment strategy
When creating a dividend-based strategy, it is important to establish your overall aim. Decide whether you’re looking to receive a regular income stream, balance out riskier positions or take advantage of compounding.
Regardless of your motivation, remember that dividends are not guaranteed. Buying a fund style product, such as an ETF of dividend stocks, mitigates the risk of a single stock suddenly scaling back on its payments to shareholders.
Tip: Reinvesting dividends using Dividend Reinvestment Programs (DRIPs) can lead to compound returns. Each time a dividend is paid, the size of your stock position grows, meaning your next dividend payment will be larger, further increasing the size of your position, and so on.
Final thoughts
A company that pays a regular and above-average dividend can be seen as a safer bet than some alternatives. Many blue-chip stocks fall into this category. These stocks might not offer explosive capital growth, but if dividend payments are managed well, they can form an important part of a considered investment plan.
Learn more about the potential of dividend stocks by heading to the eToro Academy.
FAQ
- What is a dividend record date?
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The dividend record date is the date on which a company compiles a list of its shareholders. This record will be used to calculate which investors receive dividend payments, and how much will be paid out. The dividend record date is announced in advance so that investors can establish whether their purchased stock will receive dividend payments or not.
- How do I identify dividend stocks?
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There are a number of ways to determine whether a company pays dividends or not. Using adividend calendar will provide a new investor with all of the necessary information to identify dividend stocks. Alternatively, visit the company’s financial pages or the stock exchanges on which they’re listed to see whether they pay dividends or not.
- How do I evaluate dividend stocks?
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The dividend yield of a stock is a metric that can be used to compare the amount of dividends paid by different companies. It is calculated by dividing the amount of the dividend by the share price, and is expressed as a percentage. This should help you to determine whether a stock is a good fit for your investment portfolio.
- How can I establish when a dividend will be paid?
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Companies must declare, in advance, the date that a dividend will be paid. Closer to the time, they must also declare the amount that will be paid out. This information is picked up and shared by brokers and online research platforms, but investors can most reliably find this information from the Investor Relations section of a company’s website. For example, the details for British Land Plc are laid out clearly in the company’s online financial calendar.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.