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Dividend stocks explained: how to generate income through shares

In the current low-interest-rate environment, many people are ditching their savings accounts and turning to other investments in an effort to generate higher returns on their money. ‘Dividend stocks’, which offer high levels of income compared to savings accounts, are one such investment. 

Don’t know what dividend stocks are? Don’t worry. Here, I’ll explain how they work.

What is a dividend stock?

A dividend stock is a share in which the underlying company pays out a proportion of its profits to shareholders, in cash, on a regular basis. These cash payments are called ‘dividends.’ It really is quite a simple concept to grasp – if you own a dividend stock, you’ll receive cash payments from the company (usually twice or four times per year) simply for being a shareholder.

Here in the UK, there are many dividend stocks listed on the London Stock Exchange. Examples include Royal Dutch Shell, Lloyds Bank, and Legal & General.

How much income do dividend stocks pay?

Every dividend stock has its own dividend ‘yield.’ This is a similar concept to an interest rate on a bank account. For example, if a stock has a dividend yield of 5% and you have £1,000 invested, your dividend will be £50 per year.

Dividend yield is calculated by taking the company’s dividend per share and dividing it by its share price. Looking at Lloyds, it declared a dividend of 3.21p per share last year and its share price is currently 61p. That means the dividend yield is 5.26% (3.21/61 = 5.26).

Other examples of dividend yields available right now include:

  • Royal Dutch Shell: 6.5%

  • Legal & General: 5.8%

  • GlaxoSmithKline: 4.6%

  • BT Group: 8.2%

Be careful with high yields

While dividend stocks can offer excellent yields, you do have to be careful with really high yields (7%+). That’s because companies with super-high yields are often experiencing problems. What’s happened is that a lot of investors have already sold the stock, which has pushed the share price down and the yield up. Quite often, these kinds of companies go on to cut their dividend, which isn’t what you want as a dividend stock investor.

What to look for in a dividend stock

There are a few things you should check before investing in a stock for its dividend. These include:

  • Dividend growth – ideally you want a company that has a consistent dividend track record and has grown its dividend over time

  • Revenue and earnings growth – this will help the company increase its dividend

  • Dividend coverage – this is the ratio of earnings per share to dividends per share. It gives an indication of whether the company can afford its dividend. Look for a ratio above 1.5

  • Debt – companies with high debt are more likely to cut their dividends in the future

Risks

Of course, as with any investment, there are risks associated with dividend stocks. It’s important to be aware that, due to the volatile nature of the stock market, you might not get back what you invested. Even if you pick up a 5% yield on a stock, you could still lose money if its share price falls heavily. Secondly, dividends are not guaranteed. A company can cut or reduce its dividend at any time.

Overall though, dividend stocks can be a great way to build up an income stream. Compared to savings accounts, they offer the potential for much higher returns.

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Edward Sheldon owns shares in Lloyds Bank, GlaxoSmithKline, Royal Dutch Shell, and Legal & General Group. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.