Dividend and Conquer!
As the team build up our portfolios, we’re also testing our process for dividend payments. With this in mind, we thought now would be a good time to take a deeper dive into dividends.
What are dividends?
Dividends are a distribution of company profits paid proportionally to the shareholders. They can be drawn from some or all of one or more years’ profits and are usually but not always paid semi-annually.
In the context of a portfolio or a fund, dividend paying investments are often referred to as income or income stocks. You don’t receive dividends if you speculate on the stock with a spread bet, but you do indirectly receive the dividends from stocks held in a fund you own.
From a tax perspective, dividends aren’t a capital gain — they’re treated as income.
In the UK right now, everyone has a standalone £2000 dividend allowance for the year. Anything above that stacks onto your income and is taxed at different rates based on your income taxpayer rate (regardless of whether you choose to reinvest the dividends).
Check out this post for more info on dividend taxation.
Local tax laws often factor into how and whether a company chooses to use dividends to return value to its shareholders or goes for other methods like share buybacks.
Significantly, dividends paid on stocks you hold in an ISA or pension are totally free from UK tax upon receiving them and don’t impact your allowance.
When do I receive dividends?
Companies that issue regular dividends usually pay annually or semi-annually.
However, the dividend doesn’t just go to whomever holds the stock on payment day. Instead when companies set the payment day for dividends, they assign a record date to check their shareholders in line for the money.
Companies also set an ex-dividend date before the record date. The ex-dividend date is usually a few business days before record date.
An ex-dividend date is the day on which the stock no longer trades with the right to the upcoming dividend. If someone sells a stock on or after ex-dividend day, that seller still gets the next dividend, not the buyer.
- Ex-dividend date: on and after this date, the buyer of the stock won’t receive the upcoming dividend
- Record date: company checks shareholders of record with entitlement to dividend (all shareholders who bought before ex-dividend date)
- Payment day: dividend is paid
The ex-dividend date essentially creates an intentional lag in dividend rights due to the administrative difficulties companies face paying dividends to a very new shareholder (whose trade might not settle before the record date).
Ex-div stocks, stocks which have passed their ex-dividend day, often trade at a small deficit because of this missed dividend.
What should I do with my dividends?
Well, you could just consider them income and use them to buy whatever you like — jet-skis, gingerbread, handbags … a twix. Historically, many people used dividend payments as supplementary or retirement income. 👴
But you can also just reinvest them! This is the portfolio ninja’s way.
Automatic dividend reinvestment is a brokerage feature through which your dividends are automatically reinvested into the relevant stock or ETF (unsurprisingly). We won’t have this feature at launch; for now, dividends will be paid into your Freetrade account as cash. However, it’s a priority on our roadmap. It’s a cool way to maximise your compound interest.
Reinvested dividends are still subject to the same income tax rules, unless generated in an ISA or SIPP.
Do all stocks pay dividends?
No! In fact, paying dividends is not quite as common as it used to be.
The company board has discretion over whether or not to pay out profits as dividends. Alternatively, it can simply retain the money as cash on hand or more often reinvest the profits to try to grow the business.
Some companies opt to reinvest profits on the basis that if the company’s worth owning in the first place, it should be able to create more value from this money.
It’s rare for a young or high growth company to pay dividends and much more common for well-established, long-lived companies.
Sectors that tend to have a high number of dividend stocks include telecoms, utilities (esp. energy), industrials, financials and property. Most stocks in the FTSE 100 pay regular dividends but relatively fewer in the US’s S&P 500.
What’s dividend yield?
A dividend yield is the dividend payment/share expressed as a percentage. It’s calculated as the average dividend amount per share divided by the current share price.
There are a couple of different approaches to finding the dividend figure calculation, but the most common is to plug in the last dividend paid (annualised historic dividend).
A ‘high’ dividend yield is subjectively and historically relative but right now over 5% is quite high and over 10% is very high.
A high dividend yield could be a sign of a mature company with a strong, stable earnngs pattern, but it could simply mean a formerly healthy company in decline.
Let’s look at why.
Imagine the totally fictional Larry Peterson Crane Company is priced at 10 Baht/share (they’re Thailand’s biggest fictional crane firm!)
If they were to pay 1 Baht of annual dividends for every share held, they would have a 10% dividend yield.
The obvious standout there is that word ‘annual’. When paid, dividends are usually issued once or twice a year, but share prices fluctuate all the time.
So the dividend yield fluctuates much more because of share price than the actual dividend.
This can run you into some complications.
Now, let’s say Thailand stonewalls planning permission for skyscrapers. The outlook for construction companies changes overnight and Larry Peterson Crane stock crashes to 5 baht/share. However, the dividend is still calculated with the last annual figure — 1 baht/share.
So now there’s a seemingly attractive 20% dividend yield, but only because the stock is going down faster than the upper sheave on a Larry Peterson crane. 👷
Even if they manage to pay the same dividend next year, you could still be losing the long-term value in the investment itself, as the company’s long-term prospects decline.
And Dividend Cover?
Dividend cover is the proportion of profit to dividend, calculated as post-tax profit divided by the dividend.
If Larry Peterson Cranes makes 3 baht/share profit and pays out 1 baht/share dividend, the dividend cover is 3.
As a metric, dividend cover can help you the sustainability and stability of a company’s current dividend level.
If a company only pays out a relatively smaller proportion of its profits, it has a better chance of sustaining that level in the future. A cover of 2+ usually indicates a fair amount of stability.
However, it can’t be relied on completely.
As in our Larry Peterson example, it won’t necessarily safeguard you from a stock that managed a good profit and a good dividend but then went into free-fall due to a deep market change.
Finally, what’s dividend irrelevance?
There’s also an economic theory (Modigliani-Miller) that claims dividends are essentially irrelevant to investors: a company has a certain value based on its profits and whether an investor achieves cash flow through dividends or selling stock is irrelevant.
However, this is only true in a world where all income and gains are taxed the same, where investors are rational and future prices and dividends can be predicted with certainty.
Since we do not live in such a world, dividend irrelevance is irrelevant. 🔥
Dividends are an excellent way to flex your investment between capital and cash. They’re also a powerful reminder that a stock isn’t just some financial instrument — it’s a real stake in a huge public company.
Head to the forum to request any more info and discuss all your dream features around dividends.
We’re on a mission to bring fee-free investing to Europe and beyond. 🔥
Freetrade does not provide investment advice and individual investors should make their own decisions or seek independent advice. The value of investments can go up as well as down and you may receive back less than your original investment. Tax laws are subject to change and may vary in how they apply depending on the circumstances.
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