What are dividend stocks, and why are they crucial in stock markets?

What are dividends on stocks?

Dividend-paying stocks might just be the inflation buster that investors seek right now. With inflation in the UK currently a clip over 10%, any respite from soaring inflation is welcome.

But what is a dividend, you ask? A dividend is part of a company’s earnings that is paid out to shareholders.

Dividends are typically paid out on a quarterly basis. They are paid out as cash or in the form of re-investment in additional stock.

Think of a dividend as a “thank you” to shareholders. The paying of a dividend encourages shareholders to keep on supplying their capital, which the company can use this to fund expansion.

When companies do well and generate healthy levels of cash, the dividend they pay can increase. Conversely, if the company is looking to cut costs after a poor financial year, it may reduce its dividend payout.

A useful metric for assessing a company’s dividend is the dividend yield. This is what’s paid out as a percentage of the company’s share price, which gives a more accurate reflection of the amount of dividend it pays.

For example, if a company’s shares sell for 100Bp each, and it has a dividend yield of 5%, you can expect 5GBp in annual dividend for every 100GBp invested.

Regardless of whether the company’s stock price goes up or down, you’ll receive dividend payments as long as the company continues to disburse them.

However, bear in mind that the shares can also drop in value, so a dividend yield may be offset with a capital loss. 

Which stocks pay dividends?

Companies from a variety of different industries pay dividends. These include technology, financials and customer staples and utilities.

For example, tech giants Apple and Microsoft both currently pay a dividend. Apple’s dividend yield is very small, coming in at 0.58%.

Typically, the higher dividend-paying companies are in the utilities and consumer staples sectors.  Utilities, which include water and energy companies, have limited growth potential because governments often regulate their selling prices.

What’s more, because they generate healthy levels of cash, (which they’re unable to use for expansion) they have plenty of scope for paying surplus profits as dividends to shareholders. For instance, oil and natural gas company Viper Energy Partners currently has a dividend yield of 10.4%.

In addition, dividend-paying companies are usually more established – rather than younger – companies. Young companies need to re-invest their profits if they are to expand, rather than pay them out to shareholders.

When is the best time to buy dividend stocks? 

According to investment bank Goldman Sachs, the best time to buy dividend stocks is during periods of high inflation (above 5%).

In other words, right now.

The logic is as follows.

Inflation is typically bad news for many, but not all, company share prices. High inflation brings the expectation of higher policy interest rates, as investors anticipate action from the central bank to “cool down” the overheating economy.

When interest rates do rise, the return on cash and bonds increases, making riskier shares less attractive. Share prices then drop due to lower demand for the shares.

Remember that the dividend yield is calculated as a percentage of the current share price. In other words:

Dividend yield = (dividend per share/market price per share)*100.

So, when the share price goes down, the dividend yield rises.

A high dividend yield may seem attractive, but you need to be careful. If a company is experiencing financial difficulties or structural issues, causing its share price to fall, the high dividend yield becomes unsustainable and unrealistic.

This could lead to the company cutting the dividend, and the falling company share price could leave you with a greater capital loss.

To avoid this trap, it’s best to invest in dividend-paying companies that have a solid track record of paying high dividends.

This chart from Fidelity indicates that stocks paying a dividend yield between 5% and 7% are optimal when considering the risk to reward. Nevertheless, dividend-paying stocks are useful to have in your portfolio.

Having the safety net of a consistent dividend payout may be more appealing to you than a more volatile stock that could perform better during the good times, but also worse during the bad times.

Tech stocks and crypto-centric stocks spring to mind here.

In terms of when you actually buy the dividend-paying stocks, be careful not to make this rookie mistake. You need to be aware of the ex-dividend date.

The ex-dividend date is the last date for which an investor can purchase stock in the dividend-paying company and expect to receive a dividend. If you buy a stock on or after this date, you will not receive a dividend on the next payment date, and will have to wait for the next payment.

The ex-dividend date is typically two days before the record date, which establishes which shareholders will receive dividends.

When is the best time to sell a dividend stock?

If you did want to sell your dividend shares, doing so on or after the ex-dividend date ensures you’ll still receive the next dividend payment.

However, on the ex-dividend date, the share price typically drops by the amount of dividend to be paid. The price drop maintains the investment value of the stock.

For example, for a stock with a share price of 50GBp the day before it goes ex-dividend, with a 1GBp dividend to be paid, the share price will open at 49GBp on the ex-dividend date.

What’s more, waiting around for the dividend may prove even more costly if the share price is plummeting. So, although you will get your dividend, you need to consider the capital loss attached to holding the shares.

Then, you should also think of your dividend stock as any other share.

If the company is in poor financial shape, with poor revenue growth and a mounting pile of debt, it might be time to ditch the shares. Look out for a lack of commercial progress, too.

Finally, using the above formula, an environment of low inflation and “risk-on” sentiment could mean that certain companies pay a lower dividend yield.

Other riskier assets may provide greater opportunities for capital gain, so dividend-paying shares may be overlooked at their expense.

Which stocks have the highest dividend?

On the London Stock Exchange, the three equities currently with the highest dividend yields are:

• Kakuzi plc: this company manufactures agricultural products. Its dividend yield is currently 16.11%.
• Persimmon plc: this company is a UK-based housing developer. Its dividend yield is currently 15.47%.
• RM plc: this company provides information technology products and services. Its dividend yield is 15.16%.

You can see all dividend-paying stocks on the LSE by using the Financial Times stock screener. Take a look here.

How to buy stocks that pay dividends  

The first port of call would be the company website. Companies will reveal their dividend yield in their latest financial statements.

Stock screeners are also a great way to find stocks that pay dividends.

Aside from the Financial Times stock screener mentioned above, another good place to look is Market Beat, where you will find some of the highest dividend-paying companies worldwide. You can access it here.

You should also be able see a company’s dividend yield through your broker. Then, if you wish, you can purchase the shares of any dividend-paying company just as you would for any other stock.

During these turbulent times, adding some dividend-paying stocks to your investment armoury could be an astute way to fight inflation.

Until next time,

Elliott Playle
Contributing Editor, Exponential Investor