What Are Dividends?

Dividends are such a large potential topic that you will find a whole section of this site dedicated to them. However, they fall potentially into several categories, so here is a quick guide instead of the indepth analysis.

As I am sure you already know, a dividend is a payment made to an investor on an annual or semi-annual basis. It is, in essence, a return of money to shareholders that represents a small part of the profits earned by the investors holding.

The relationship between the net income from a share and it's price is known as the 'dividend yield'. It is defined as:

net dividend divided by share price x 100%

Dividend Cover

Usually a company will only pay out a small proportion of the profits available. The dividend cover ratio is used to gain an idea of how safe the payment may be. Should profits in the future fall and the dividend cover ratio is very low, these falling profits could turn into reduced dividend payouts. Should a company cease to pay dividends or reduce them unexpectedly, you can be sure that the price of the share will be influenced and not in a good way!

dividend cover = earnings per share divided by net dividend per share

I have seen research that suggests that up to 70% of the long term returns on stock market investments (when indexed against inflation) are actually due to the dividend payout. This makes it very important that you consider shares with an annual yield for your portfolio.

Remember that investment is a long term game. Very few investors actually double their money in a 12 month period, which means that it pays to look closely at the extra boost that a dividend will provide.

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Another very important point to remember is that it is vital to reinvest your dividends should you have the opportunity. Many big firms now offer a reinvestment plan which allows the investor to purchase more shares in their firm each year with the annual dividend payment. This helps to make the shareholders long term owners rather than quick turnaround traders and also makes it easier and lower cost to reinvest.

Research suggests that long term reinvestment can make a difference of several percentage points per year difference over the longer term ( for example, this pdf ).

There are a number of schools of investment theory that recommend selecting companies to invest in by assessing their annual payments to shareholders. These have some real merit.

When businesses are compared closely, there are some that literally throw off cash and profits and can afford to pay significant amounts out to shareholders every year. And there are other businesses that simply will never manage this. In large part, this relates to the economics of the business model and sector, despite how management insist that it relates to their own superior skills...

These businesses that make truckloads of money are usually priced more highly in the stock market and have a higher price to earnings ratio. Their ability to reward shareholders is a significant part of this as is described in this guide .

Other relevant pages are:

How To Use Risk Analysis To Make You A Better Investor

Investment Definitions

Understanding A P/E Ratio (Price To Earnings Ratio)

What Does The Return On Capital Employed (ROCE) Tell Us?

Liquidity Ratios: The Current Ratio and the Quick Ratio Explained

Operational Gearing: The Impact of Borrowed Money on Trading Profit

Understanding Gearing And Borrowed Money

Understanding Different Types Of Risk

Why Low Risk Can Be Good

Why Selling Investments Is THE Most Important Skill You Can Learn In Investing

What Is A Stop-Loss?

How Does Volatility, Standard Deviation and Beta Impact An Investment Portfolio?

What Is Alpha? Can You Outperform The Stock Market?

Learn How Beta And Volatility Impact Your Investment Portfolio

Does Correlation Influence Portfolio Diversification?