A dividend is a payment a company makes to its shareholders out of its profit. Most dividends are cash paid per share, but some companies pay in additional shares instead, which is usually called a bonus issue or a scrip dividend. A company pays a dividend when its board decides to share some of the profit, rather than keeping all of it for the business.
Dividends are one of the two ways a shareholder makes money from a stock, along with the rise in the share price. They are attractive because the income arrives regardless of market moves, but they are not guaranteed, and a high dividend can be a warning sign as well as a reward. This guide explains how dividends are paid, how to measure them, and what to look for in a payout.
How a dividend is declared and paid
A dividend usually goes through three steps. The board announces the amount per share and the dates. The company then pays the money on the payment date to the shareholders who were entitled to receive it. The date that decides who is entitled is covered in the guide on the ex-dividend date.
The amount is declared per share. If a company declares a dividend of 2 per share and you hold 500 shares, you receive 1,000 before tax. Some companies pay in more than one instalment during the year, for example quarterly or half-yearly. Others pay once a year, often after the annual results.
Check the rules in each market, because payment timing, tax and the form of the dividend differ. Some markets withhold tax at source, and some pay in local currency only.
Dividend yield
The dividend yield measures the income relative to the share price. It is calculated as the annual dividend per share divided by the current share price, and it is usually shown as a percentage.
Dividend yield = annual dividend per share ÷ share price
Suppose a share costs 80 and pays an annual dividend of 4 per share. The yield is 4 ÷ 80, which is 5 percent. If the share price rises to 100 with the same dividend, the yield falls to 4 percent. If the share price falls to 60, the yield rises to about 6.7 percent.
That last point is the first trap. A yield rises when the price falls, even if the dividend has not changed. A high yield can mean good income, or it can mean the market expects the dividend to be cut and has already pushed the price down. Always check the reason before treating a high yield as an attractive feature.
Payout ratio
The payout ratio shows how much of the company's profit it pays out as dividends. It is calculated as the dividends paid divided by the profit for the same period.
Payout ratio = dividends ÷ profit
A company that earns 10 per share and pays 4 has a payout ratio of 40 percent. The remaining 6 is kept in the business. A payout ratio close to or above 100 percent means the company is paying out all of its profit or more. That may be sustainable for a while, for example if the profit is temporarily low, but it leaves no margin for a bad year.
For a company with growing profit and a stable payout ratio, the dividend tends to grow over time. For a company whose payout ratio is rising because profit is falling, the dividend is at risk.
What a dividend cannot tell you
A dividend is not a sign that a company is healthy, and a company that pays no dividend is not necessarily weak. Young companies that are growing fast often reinvest all their profit, because the return from that reinvestment is higher than a shareholder could earn elsewhere. Others pay dividends because they have few good places to invest, which is not the same thing as being a good business.
A dividend is also paid out of the company's cash, so a payment can reduce the company's resources. A company that borrows to pay a dividend is not generating the income it is paying out, and that is worth checking in the cash flow statement.
Finally, a dividend does not protect the share price. On the ex-dividend date the price typically adjusts down by roughly the dividend amount, so the shareholder receives the cash but the share is worth less by the same amount. Total return, which is the price change plus the dividend, is what counts over time.
A worked example: total return
Suppose you buy a share at 80 and hold it for a year. It pays a dividend of 4 and the price ends the year at 84. Your total return is the price change of 4 plus the dividend of 4, which is 8 on a cost of 80. That is a 10 percent total return: 5 percent from the dividend and 5 percent from the price.
Now suppose the same share ends the year at 70 but still pays the dividend. The price change is minus 10, and the dividend is 4, so the total return is minus 6, or about minus 7.5 percent. The dividend cushioned the fall but did not remove it.
| Scenario | Dividend | Price change | Total return on 80 |
|---|---|---|---|
| Price up to 84 | 4 | +4 | +10% |
| Price down to 70 | 4 | −10 | −7.5% |
Look at the total return over several years before judging a dividend stock. A high yield that is eaten by a falling price is not a good result.
Reinvesting dividends
Many investors reinvest dividends, using the cash to buy more shares. Over long periods, reinvestment makes a large difference to the total return, because the reinvested dividends buy more shares that earn their own dividends. The effect works like compound interest, and the guide on compound interest shows the arithmetic.
Reinvestment is simple to set up with some brokers and funds, and it is worth checking whether it is available for the market you invest in.
Tax on dividends
Dividends are often taxed, and the rules differ by country and by the kind of investor. Some markets tax dividends at source. Others tax them as income, sometimes at a different rate from capital gains. Some countries give credits for tax already paid abroad. These rules change, so check the current position with a tax adviser in your own country before you plan around a dividend.
Checklist for a dividend
- Check the declared amount, the frequency and the dates.
- Work out the yield, and check the price history that produced it.
- Check the payout ratio, and whether profit and cash flow cover the dividend.
- Look at the dividend history over five to ten years, and whether it has been cut.
- Compare the total return, not just the yield.
- Check the tax treatment where you live.
Key takeaways
A dividend is part of a company's profit paid to its shareholders, in cash or sometimes in shares. Dividend yield is the annual dividend divided by the share price, and the payout ratio shows how much of the profit is paid out. A high yield can come from a falling price, and a payout close to 100 percent leaves little margin. The share price adjusts after the dividend is paid, so the return that matters is the total return, combining income and price change. Check cover, history and tax before you rely on a payout.
This guide is for general information, not financial advice. See the disclaimer.