FOOL SCHOOL
All About Dividends

August 1, 2005

One of the joys of investing is hearing the thud of a dividend cheque when it comes through your letter box. But the subject of dividends often confuses. So here's our introductory guide.

1. What are dividends?

A company exists to allocate its resources in the most efficient manner for the long-term benefit of its shareholders. Each year, hopefully, it will make a profit. Typically it will keep some of its profits back in order to expand the business or to cushion its own cash position. It will pay the remainder to its shareholders via a dividend.

A company's management decides how much each dividend payment will be. Once it is declared it is paid to every shareholder. But companies are under no obligation to pay a dividend of any set level.

Younger companies in growth markets are far more likely to pay a small or no dividend so that they can fund further expansion. In contrast, more mature companies in slower growing markets are likely to pay higher dividends because they do not have the opportunity to invest in expansion.

Most companies try to steadily increase their dividends each year as this is what most fund managers prefer to see. However, if a company is struggling it could cut its dividend level by a third or more, hoping that it can resume a steady upward path in future years. Often the directors of a company will tactfully describe such a cut as a "rebasing"!

2. How and when are they paid?

In the UK dividends are normally paid twice a year, after a company's interim and full-year results. A typical split is one-third at the interim stage and two-thirds at the year-end. Some larger companies pay out dividends each quarter.

When a company publishes its results, normally between one and three months after the end of each half-year period, it will declare how much and when its next dividend payment will be. The exact date of payment will vary from year to year, although last year's payment date should give a rough indication of when you should expect your lolly. When a dividend declaration is made the company will announce three dates alongside the payment. These are the ex-dividend date, record date and payment date.

The first date is when shares go ex-dividend: in other words, only shares bought before this date entitle their owners to that dividend payment. And, as you might expect, on that date the share price generally falls by the amount of the dividend to reflect the fact that any subsequent buyers of the shares aren't entitled to this payout.

The record date (normally a couple of days after the ex-dividend date) is when the company looks at its share registrar and takes the details of everyone who currently owns its shares. On the payment date these are the people that will be sent their dividend payments. Be careful if you do happen to trade in the shares around the ex-dividend date as companies do sometimes make mistakes about who they pay the dividend to. You may need to chase up your broker if you don't receive dividends that you are entitled to.

Note that if you buy the shares between the ex-dividend date and the payment date then you won't be entitled to that dividend. In newspapers this is often denoted by the letters 'XD' (pronounced ex-div) next to the share price. If you sell shares on or after the ex-dividend date you are still entitled to receive that dividend.

3. Dividend yield

Dividend yield is a simple ratio than can be used to compare dividend rates for different companies. It is the latest annual dividend divided by the share price and expressed as a percentage. For example, a company with a dividend of 20p and a share price of 400p has a dividend yield of 5% (20p/400p times 100). Dividend yields can either be historical (based upon the dividend paid for the last full year) or forecast (based upon what analysts think the next full-year dividend will be).

The dividend yield is used by many people as a valuation yardstick, that is a measure to determine whether a company's shares offer good value or not. There is more about this concept in this article.

Currently, the average yield for UK shares is around 3%. Shares yielding higher than this (often called high yield shares would you believe!) are often sought after by those looking for a decent income. But you need to treat high-yielding shares with some caution. Just because a generous dividend was paid last year does not necessarily mean the same will happen next year. When a company is in trouble, and its share price falls, its historical dividend yield could rise to 10% or even higher. In most cases this is a good indicator that the stock market thinks the next dividend will be much lower or no dividend will be paid at all, so always check for forecasts to see if a dividend cut is being predicted.

4. Dividend cover

Wouldn't it be useful to have some method of assessing how secure a company's dividend might be? Another ratio, called the dividend cover, can help you do this. It is calculated by dividing profit after tax by the total amount paid out in dividends. For example, if our company made £50m in post-tax profits last year and paid out £25m in dividends it would have a dividend cover of 2 (£50m/£25m).

A dividend cover of less than 1.5 times is often seen as a warning sign that a cut may be in the offing. A ratio of over 3 times is usually considered as comfortable. But these are only general rules. Another thing to look at is a company's net cash position. A company with plenty of cash reserves which sees its profits dip is much more likely to carry on paying the same level of dividends.

5. The taxation of dividends

All dividend payments declared by companies are effectively net of basic rate income tax. This means that, unless you are a higher rate taxpayer, you do not have to pay any further tax on dividends you receive. Higher rate taxpayers pay tax of 25% of the net amount paid. A higher rate taxpayer who received £80 of dividends therefore would be liable to pay £20 of additional tax.

If you have your investments within an ISA or PEP however, you pay no tax on your dividends even if you are a higher-rate taxpayer. See our ISA centre for more on ISAs.