Why do you invest in shares? To make money. And how do you make money out of shares? The most obvious way is to sell the share for more than you bought it for. That gives you what's called a 'capital gain'.
But there's another way to make money from shares. That's through dividend income. And dividends are absolutely critical to your returns as a shareholder in the long run.
Research shows that since 1925, nearly half of the return an investor would have made from the S&P 500 (the main US stock market) came from reinvesting dividend income into shares.
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So how do dividends work?
A dividend is a chunk of the company's profits that gets paid out to shareholders. Each year, the directors have to decide how much of each year's profits (assuming they make any), will be paid out to shareholders in the form of a dividend, and how much will be retained to grow the business.
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The two are mutually exclusive in that, if profits (after tax) are £100,000 and £50,000 is paid out as a cash dividend, then only £50,000 can be kept back by the directors for growth.
That's why some firms grow fast but pay low dividends (technology firms are typical) and others offer high dividends but lower growth prospects (utilities often fit this description).
Dividend yields: how much is the company paying me?
The return from dividends on any given stock or share index is measured by the dividend yield. This is the latest annual dividend, divided by the current share price as a percentage. (You can also use the 'prospective' dividend payout ie what the company plans to pay out next year to give you the prospective dividend yield).
So if the annual dividend is 5p per share and the share price is £1.00, the yield is 5p/£1 as a percentage, so 5%.
Dividend safety: will they actually pay out?
Companies don't have to pay out dividends. And just because they paid one this year, doesn't mean they have to do it next year.
Sure, generally speaking, companies would rather not cut their dividends. A dividend cut is almost always a very obvious sign that something has gone wrong, and it often results in board members falling on their swords (or being pushed). But it can and does happen.
So it's important to safety check the dividend, to test just how sustainable it is especially if the dividend yield looks particularly tantalising.
Finding the best stocks
Reliable dividend-paying stocks can form a vital bedrock to any investment portfolio as they throw out income, thick or thin. Once you've mastered the basics of dividends you'll want to start hunting down your own dividend gems. Here's a recent piece on how to go about it: Three ways to spot dividend gems.
