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What are dividends?

I couldn’t be more excited to welcome a new addition to Team Monevator! The Analyst is a good friend of mine, and I can vouch for his investment knowledge, his desire to educate and to learn, his Rockefeller-like passion for dividends, and his tactical nous playing Settlers of Catan. I’m sure those readers who (like me) enjoy active investment will soon be eagerly awaiting his latest posts.

Whether your aim is to maximise current income or grow your capital, dividend-paying shares can be a good match for individual investors who want to directly hold a portfolio of shares, but who don’t want to succumb to excessive trading and speculative activity.

Though it’s been nice to see the increased interest in dividend shares over the past few years, there remains a lot of misunderstanding about dividends, the proper way to manage a dividend portfolio, and how to separate good dividend shares from bad ones.

In the next few months, my aim is to start from the ground up, to help create a lasting source of dividend education for and with the Monevator community.

What are dividends?

To understand what dividends are, first we must review what a share represents to an investor.

When you buy a share of a company, you’re literally doing just that – buying a share of the company itself – and by doing so you become part-owner of that business. You may not have much say in the company’s day-to-day operations, but you nevertheless get to share in the company’s profits and normally receive the right to vote on corporate policy.

As a company grows and matures, it typically becomes more profitable (otherwise it probably wouldn’t have lasted that long) and produces more cash flow. Concurrently, however, the maturing company frequently finds that it has fewer suitable investments in which to reinvest all the extra cash it’s generating.

When this happens, companies often decide to return some of the extra cash to shareholders in the form of dividends rather than hoard it or reinvest it in value-destroying projects. And because you own a fractional share of the company, you are entitled to receive your proportional amount of the dividend paid to shareholders.

We’ll discuss dividend policy in more detail in a future part of this series, but for now the important thing to remember is that dividends are cash paid by companies to shareholders.

This may seem elementary, but it is an absolutely critical concept to remember when evaluating dividend-paying shares: unless the company generates more than enough cash to sustainably fund the dividend, the dividend is more likely to be cut or suspended.

From time to time we hear about companies cutting their dividends, and there’s always a group of investors that didn’t see it coming. In future articles, I will introduce ways to notice a risky dividend by paying attention to cash flows and a company’s financial health.

What dividends are not

One common misconception about dividends is that they’re paid out of a company’s profits.

It’s easy to see why some investors may think that’s the case as the ‘dividend cover’ ratio – earnings/dividends – is the primary dividend health metric found in financial data sites and analyst reports.

The problem is that earnings are an accountant’s opinion and do not 100% translate into tangible cash. A company with aggressive accounting policies, for example, can artificially boost reported earnings for a time whilst generating less actual cash flow. This can make the company’s dividend look healthier than it really is.

As investor curiosity about dividends has increased, so has the misconception that income generated from dividends is a perfect substitute for the low interest rates currently being offered by fixed income products.

But dividends from shares are not a straight replacement for fixed income.

  • A bond is a contractual lending agreement between you and a company in which you lend a set amount to the company and in return the company will repay you interest at an agreed-upon rate and schedule, and at maturity the company will pay you back the amount you originally lent it.
  • With shares on the other hand, there is no maturity date, no contractual obligation to pay interest or return capital, and in the event of bankruptcy ordinary shareholders usually get nothing while creditors tend to get some of their capital back.

Dividends are not guaranteed. If the company runs into hard times and isn’t generating enough cash, it can cut or suspend its dividend. As such, investors keen on moving money from low-interest bonds to higher-yielding shares should be fully aware of the differences between shares and bonds.

Make no mistake – dividend-paying shares, properly vetted and assembled in a portfolio, can be an excellent tool for generating income. The key thing to remember is to not allocate funds to shares for higher yields alone.

Be sure that the funds you’re reallocating to shares will not be needed in the short-term and that you’re comfortable bearing the risks inherent to shares.

Until next time

We’ve covered some basics here, but I think it’s important to start from the beginning and build a good foundation of knowledge. In the next article I’ll continue with this bottom-up approach by explaining what we mean by dividend yield.

Until then, please post your comments, questions, and thoughts below!

You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

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{ 31 comments… add one }
  • 1 Steve August 23, 2012, 11:24 am

    Welcome Analyst!

    Never mind this investing stuff …. do you play other games besides Settlers?

  • 2 Rob August 23, 2012, 11:30 am

    Best summarised as;

    Turnover is vanity
    Profit is reality
    Cash is sanity

    Dividends have two features which make them ideal for using as the core of an investment process.
    First, you get a tangible confirmation that they actually exist when the cheque arrives.
    Secondly, they can never be restated unlike EPS or book vaue.

  • 3 Julie at Nutmeg August 23, 2012, 11:50 am

    Welcome and thanks for starting this series, Analyst. I look forward to reading the next articles!

  • 4 The Analyst August 23, 2012, 12:44 pm

    @Steve: Cheers! I like any game that requires skill and practice to be a consistent winner (poker, etc.) — just like investing! Games of chance aren’t of much interest to me.

    @Rob: Absolutely. Both good points!

    @Julie: Cheers! And I look forward to writing them. 🙂

  • 5 gadgetmind August 23, 2012, 1:13 pm

    Thanks for this.

    I have a trifurcated investment strategy with the bulk in trackers, some in “Steady Eddie” ITs such as PNL, and the rest in income holdings such as REITs, preference shares, and high-yield equities. My dividend equities are doing well so far but I’m always eager to learn more.

  • 6 Steve August 23, 2012, 1:24 pm

    @The Analyst: you like Settlers but not games of chance? Have you not had a game where nobody rolls 6 or 8, and everyone rolls 2 & 12?

    back on track…

    Hopefully your series will touch on many aspects of dividend income. This approach constitutes a fair percentage of my holdings, but I’m learning on the job, so it would be great to increase my confidence in how I go about things – there’s always something new to learn.

  • 7 The Analyst August 23, 2012, 2:29 pm

    @gadgetmind: Sure thing. Sounds like you have a well-thought out strategy there — building a foundation with trackers and ITs and adding your own personal touch with income holdings.

    @Steve: Alas, yes. You can play the odds as much as you’d like, but it’s still frustrating when they don’t work to your advantage. Yes, we’ll touch on many aspects of generating dividend income over the next few months. The next few weeks or so will be establishing a core base of knowledge. From there, we’ll explore more advanced topics.

  • 8 Paul S August 23, 2012, 3:33 pm

    Welcome TAst,
    One important difference between bond interest and dividends is that bond interest is fixed as a nominal return and is thus at the mercy of inflation. Dividends aren’t fixed or guaranteed but usually increase with time and usually by more than inflation.
    Many of the larger companies that pay generous dividends have a stated policy of always increasing dividends and only go back on that under extreme circumstances (like flooding the Gulf coastline with crude (BP)). The dividend declared yesterday by BHP Billiton, for example, increased by 11% in spite of profits falling (they were till pretty good though).

    Look forward to your further articles.

  • 9 Moneyman August 23, 2012, 4:40 pm

    Good luck with the series!

    Dividends and fixed-income are different ways of getting your hands on the company’s cash, with the modalities varying, as described above. By contrast, ‘value’ investing is speculating on the share price movements. Personally, I’ve never lost money on fixed-income but I have with dividend shares; the yields can be higher on fixed-income too – although they don’t rise, as noted above. Anyway, I’m trying a 50/50 split.

  • 10 The Analyst August 23, 2012, 5:35 pm

    @Paul S: You’re spot on about interest and dividends. Though dividends can be cut, they do offer inflation-fighting benefits when the payout is raised, so if you can build a diversified portfolio of quality payers (subject for future article) you have a pretty good shot of keeping ahead of inflation with dividend income, even in the event of an unwelcome cut.

    @Moneyman: Cheers! My definition of value investing may be slightly different than yours, which is “searching for assets that are selling for less than their true worth.” If my research and thesis is correct, the share price should eventually approach or hopefully exceed my fair value estimate, even if it bounces around in between or takes years to reach the estimate. In the long-run the market is good at valuation — the short-run, not so much. I reckon there is good reason to approach dividend shares with a value mindset. What I mean by that is if you’re able to consistently buy dividend-payers below their true value (another article topic) you’ll probably stand a better chance of avoiding stinging losses on both the capital and income side.

  • 11 gadgetmind August 23, 2012, 6:06 pm

    I bought most of my dividend portfolio almost exactly a year ago when the US was being downgraded and the streets of London were on fire.

    When the sheep panic, they panic good, and that’s the time to think like a wolf!

    I miss the summer sales!

  • 12 Rob August 23, 2012, 7:08 pm

    The hard about investing is to get your head around the idea that capital values actually are not that important. Much more significant is the steam of cash flow that comes from dividends, gets reinvested and the compounding effect of both.
    That is why 90% of equity market returns over the long term come from dividends, not from capital growth.

  • 13 RetirementInvestingToday August 23, 2012, 9:19 pm

    Hi and Welcome The Analyst

    Intersting that you challenge dividend cover as a dividend continuity (or raising) predictive measure. When attempting to select a share for dividend purposes I was putting a lot of weight on:
    – Historic rate of dividend increase over typically 5 years (longer if I can get the data)
    – Minimum 5 year history of continually rising dividends
    – Operating Cash Flow per Share to Dividend per Share
    – Admittedly I was looking at Dividend Cover

    Recently though I’ve started to think that companies can also fudge cashflow statements over the short term and so have also been adding Free Cash Flow to Equity (FCFE) per Share to Dividend per Share as a metric.

    In your coming articles do you intend to dive to this level of detail? If not I’d value your thoughts on the FCFE metric as a measure of predicting dividend continuity/health.

    Cheers
    RIT

  • 14 The Analyst August 23, 2012, 9:46 pm

    @Rob: I agree that paying more attention to income than capital fluctuations can help investors stay focused on the long-term and avoid excessive trading costs. It’s a healthier way to invest. Where the market goes in the short-run is anyone’s guess.

    @RIT: Cheers! Looking at earnings-based dividend cover is fine, but I also put more weight on other factors like liquidity, history, and free cash flow cover. I’ll address free cash flow in more detail in future articles, but I do think that it is the best predictor of dividend continuity/health because it’s more of an apples-to-apples metric (cash-to-cash) than earnings (net income-to-cash).

  • 15 Rob August 24, 2012, 7:23 am

    RIT
    The fascination with historic data always tickles me. The recent results from BHP show just how quickly businesss conditions change. In financial terms last year’s results are ancient history. Even the most up to date reports include sales and costs tha are at least two months old.

    You are quite right to think that companue can fudge cash flow, they can fudge everything except the actual dividend payment to shareholders.

    The one number that I thinks is the most important is the total dividend payout. Knowing that Vodafone is expected to pay out £7 billion while Greene King will pay out a hundredth of that is, to my mind, far more relevant to allocating capital to stocks than historic ratios.

  • 16 RetirementInvestingToday August 24, 2012, 12:17 pm

    Hi Rob

    You are IMO quite right that it is the dividend per share that is all that matters to an income investor. That’s why I look for a long term track record of increasing dividends as one of my measures.

    My concern is always that companies can do long term damage (or even go bankrupt in the extreme) in the pursuit of unstable dividend increases. I’m thinking of everything from not retaining enough cash to invest in R&D at one extreme all the way to borrowing to make dividend payments at the other.

    To try and get a feel for that all I have available to me is historic data so can only use what I have. Sure it won’t always point you in the right direction but I feel it’s better than guessing.

    Cheers
    RIT

  • 17 Rob August 24, 2012, 12:44 pm

    What matters is future payments. Historic dividends are not much of a guide to what is sustainable.
    Things like share buy-backs may allow dividends per share to be increased even if the overall payout is flat. That is why I think the total payment, not the per share number, is the more important one.
    Consensus forecasts from analysts are a pretty good guide, as good as any, as to what dividends will be in the future.
    A classic example is Man Group. No one expects the current rate to be maintained, but you wouldn’t know that from the historic data.

  • 18 The Investor August 24, 2012, 1:39 pm

    @Rob — I understand why total payout might be more important if you’re trying to get outperformance via (to perhaps oversimplify) a mechanical re-jig of the index, focused on income, like you do with your fundamental tracker fund.

    However I don’t really see why total payout is a valuable metric to the average income investor weighing up the dividend stream to come from Company A versus Company B. Why do I care that Vodafone pays out a far larger cash amount than Halma, say, or Tesco? As far as I can see, what I’m concerned about is the cash I get per share, as a shareholder in any of those companies.

    Am I missing something? 🙂

  • 19 Rob August 24, 2012, 3:08 pm

    Yes, I think it gives a measure of the viability of the business and its potential growth and value as a long term business and investment. Greene King brews great beer and is well represented all over the UK. Yet it only generates £60m of dividends. Viewed as a long term business what are the chances of that doubling or tripling?
    Compare that to global buiness like SABMiller that pays out £1.1 billion from breweries all over the world and ask yourself the same question. Which do you think has better long -term prospects?

  • 20 Neverland August 24, 2012, 3:28 pm

    I think you need to pay a lot of attention to the variability of the underlying business if you want an income stock which will pay you a rising dividend

    Its no coincidence that a lot of them are multinational consumer staples like SAB or utilities

    One of my favourite dividend stocks was Dignity, the undertaker, and did offer the very predictable dividends and capital returns that you might expect

    You can easily see how much a business’ profits get affected by economic circumstances by going through old annual reports on their websites

    You will find a surprising number of companies are actually producing the same profits they did 5-10 years ago – if so how likely is their dividend to go up consistently?

    On the other hand you must keep one eye on the future – look at banks and non-food retailers

  • 21 The Investor August 24, 2012, 4:02 pm

    @Rob — Sorry, I’m at a loss to see the logic. 🙂

    I just don’t see what quoting the dividend figure without reference to the market cap of the companies (£1.2bn for Greene King versus £44 billion for SAB Miller) tells us about the future dividend stream to me, as a part-owner of one or the other businesses, investing a fixed amount of capital.

    I do know that £1,000 invested in SAB could deliver £23 next year, compared to £46 that I might expect from Greene King, just going on forward yield forecasts alone. I also know the UK has been in recession, and all the pubs have been working off structural issues, and I don’t think we’re really comparing apples to apples at all here anyway. The business models are entirely different.

    I can see a larger company is more stable, so fair enough in that general sense. And as I say I can see why you might adopt this measure for your re-spin the index style fundamental fund.

    But in general, I’d expect smaller cap companies, who will obviously deliver smaller total cash amounts as dividends per year giants (because they’re smaller!) to outperform larger cap companies.

    I know for a fact that happens with total return (the small cap effect etc) so I don’t see why dividends would be different, given their importance as you say total returns.

  • 22 Rob August 24, 2012, 6:25 pm

    This is where it is important to distinguish between dividends, the cash flow, and the yield, what you pay for it.

    Historically, small caps have offered good yields, presumably because the Market thought there was more risk attached. In the last few years though the big caps have offered better yields. In other words the Market thinks these are riskier than small caps.
    The experience of BP and the banks gives some credence to that.
    Despite those well known blow-ups I would still argue that the larger streams of cash flow are more reliable than smaller ones and therefore make better investments.
    How much you pay for that income is really a different question.

  • 23 HalfRetired August 27, 2012, 3:44 pm

    Hi Analyst
    I’m looking forward to reading your articles. I’ve experimented in the past with a range of investments – funds, low cost trackers, value shares, etc – but dividend investing from high yield FTSE 100 shares has served me best and so these now constitute the bulk of my ISA and Sipp savings.

    I think part of the reason that I like dividends is that there is something psychologically satisfying from seeing dollops of dividend drop into your portfolio – usually heralded by a broker’s email drawing your attention to it. It’s a sense of satisfaction that enhances my enthusiasm for saving, but which I don’t get to the same degree from fixed interest payments. I gather that psychological research indicates variable reinforcement schedules are generally more potent than regular reinforcement – but on the other hand, it might just be an effect specific to me.

    My situation is that I am drawing a final salary pension, but also doing some self-employed work which means that I’m still in the contributing phase for my SIPP & ISAs. Things will change in a couple of years time when I’ll be drawing income from these. So I’m hoping that you will cover the issue of taking regular income from dividends, including how to set and adjust a safety margin for stability in income and to ensure that drawings don’t overly deplete. I appreciate that you are starting from the basics of dividends and establishing and managing a HY portfolio (& anticipate I will learn things I’ve missed along the way), but how to ensure regular & enduring income from dividends seems to me to be a topic less often discussed in financial press & blogs, so I hope you will perhaps get to it before I fully retire.

  • 24 The Analyst August 27, 2012, 5:48 pm

    @HalfRetired: Thanks for your comments. Ultimately, I hope these articles offer two things — strategies for identifying solid dividend shares and strategies for assembling dividend shares in a portfolio (i.e. current income focus, building income focus, etc.). If you’re more interested in higher levels of current income going into retirement, for example, we’ll discuss ways that you can weight your portfolio toward higher yielding shares.

  • 25 Rob August 27, 2012, 6:30 pm

    HR

    You are clearly quite an experienced investor and that makes me curious as to why you have forsaken low cost trackers for a HY portfolio. History tells us that switch means lower total returns and higher risk.

    Can you enlighten us?

  • 26 HalfRetired August 29, 2012, 7:26 am

    @Rob
    I take ‘experienced investor’ as a compliment, but believe me it has just been a case of learning from mistakes as I go along.
    My experience with index investing was very similar to this:
    http://simple-living-in-suffolk.co.uk/20
    11/06/my-experience-of-index-investing/
    I too held the L&G ftse 250 index tracker over similar period of years.

    I had another foray into index investing last year when I bought some Vanguard Developed Europe index fund. Perhaps I should have seen the European storm clouds gathering, but I didn’t.

    By contrast my high yield share portfolios have served me well. Some individual shares I hold (such as Tesco) have taken a dive, but their dividends continue to arrive. I’m not convinced that holding 20+ large cap, high yield shares, chosen for good track record of dividend payment & diverse sectors, carries as much risk as you seem to be implying. But perhaps that’s a mistake I have yet to learn from.

  • 27 The Investor August 29, 2012, 11:24 am

    @Rob — Monevator cannot be accused of not giving tracker funds a fair crack of the whip — about half our content is dedicated to passive investing through ETFs and trackers. But this series is going to be about buying individual shares for their dividend income, for those who want to do that. We may well have other posts where passive/active debates are more relevant; I’d prefer it though if we could leave The Analyst’s articles for those who want to invest in individual shares (including me!) to take what they want from them, without going through that debate. Thanks.

  • 28 Rob August 29, 2012, 11:27 am

    HR,
    Interesting. I assume you concur with SL in Suffolk that conventional index funds represent dumb money. Which I also agree with you.
    You are in good company focussing on dividends as Professors Dimson, March and Siegle have determined that that is where the bulk of equity returns come from.
    The hard part is doing that in a low risk, low cost way.

  • 29 bmf August 29, 2012, 10:53 pm

    Hi – this series is really interesting – looking forward to more of it.

    I have also read your passive investing guide. Which account did you setup with TD Direct? Trading ISA? I’d like to max out my ISA allowance in passive funds and perhaps save some more on top, say adding more each month. I’m a little bewildered by the number of options under “create an account”.

  • 30 The Investor August 30, 2012, 7:41 am

    @bmf — A different author wrote the passive investing articles. You’re best asking the question at the end of one of his articles — although he’s on holiday at the moment! 🙂 A reader might be able to help though.

  • 31 Emanon August 23, 2013, 7:22 am

    If I am a passive investor and I want to sample individual stock picking how do I approach it along with my current portfolio management? Putting these stocks in the same portfolio under the same ISA for example could start to cause some admin issues….. Is it an important element to keep the two style of investing separated?

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