What are Dividends?

Dividends are one aspect of a stock that value, and predominantly long term investors look for. It is a major facet of a passive income approach where investors seek to benefit principally through means other than share price appreciation. A dividend is a portion of profits that is paid back to shareholders. It is distributed on a per share basis. There are two types of dividend payment; cash and scrip. A scrip dividend is where the proceeds of the dividend is transferred into shares. The company therefore has to issue shares for this - it is a suitable method if you intend to re-invest any dividend proceeds. For example, a company may issue a dividend of 2p per share in either cash form or scrip form or both. Cash dividends are more common. Companies who issue dividends usually do either annually, or bi-annually where the total dividend is split into:

- an interim dividend (usually paid half way through the year and is normally smaller than the final)
- a final dividend (paid at the end of the financial year)

Whether or not the company issues dividends depends on the company's market cap (i.e. its size), the company's profitability, and also the sector in which it operates. A higher proportion of companies with a high market cap pay dividends when compared to small caps. A highly profitable company is also more likely to issue dividends - however, that is not universally true as some companies may use the profits to solely strengthen their financial position. Finally, sectors such as oil and gas producers rarely pay dividends due to the high cash burn involved, and also because investors can usually gain disproportionately from share price appreciation, when compared to other sectors. Investors will search for shares with a high dividend yield. The dividend yield is expressed as a percentage - it is the percentage of the share price that the dividend covers. The formula for this is

    Dividend Yield =   Current Share Price        x 100%       
        Total Annual Dividend

There are a few dates that dividend investors have to be aware of when investing:
- Declaration Date = The date on which the dividend is announced to the market. Within this announcement, the size and relevant dates are included
- Ex-Dividend Date = This is the date on which you must be holding the stock in order to receive the planned dividend. Usually on this day the company's share price will fall roughly in line with the size of the dividend. If you are buying to obtain the dividend, you need to purchase the shares before the Ex-Dividend date
- Record Date = This date falls after the Ex-dividend Date. It is the date on which the company determines who receives the dividend, but for investors' purposes it is obselete
- Payment Date = Date on which the payment will be made to investors
 
Example of Dividend Details (BT Group)

As shown above, for the 2012/13 financial year, BT had paid two dividends (i.e. pays bi-annually). These are an interim dividend of 3p/share and a final dividend of 6.5p/share. To obtain the Final dividend, a shareholder needed to have shares in their account at the start of trading on 7th August. The payment was made on September 2nd.

The total dividend for the 2012/13 year is 6.5 + 3.0 = 9.5p. To work out the dividend yield you also need the share price which is currently 348.10p. Therefore the trailing (historic) dividend yield is 2.73%. However, working out the yield is more useful when the company provides you with forward-looking figures. For example, if BT were to pay a 10p total dividend for the next financial year, it would currently be trading on a dividend yield of 2.87%. You can use this figure to compare the dividend yields of various companies, but remember, by holding the stock you are liable to have to stand share price changes so any dividend earnings could be negated by this.

Dividend Reinvestment

Scenario assumes the reinvestment is done on a
'no commission' basis by the company
As talked about earlier, some investors choose a scrip dividend in order to reinvest the proceeds. Alternatively, investors may choose an investment plan that allows them to do this automatically. Once again, this is only really useful for very long-term investing. There are clear benefits to doing this if you make a few assumptions - the most salient being that you factor in a constant share price. An example of the benefit of reinvestment is shown to the right.

The example assumes that the company pays a total 4% dividend per year. What is shown is that over 20 years, the value of the original £10,000 investment plus proceeds reinvested, returns a £11,068 profit. For that reason, you need to be investing larger sums of money in the stock to make it worthwhile, if you are not seeking price appreciation. I believe that an active investing approach can return gains far in excess of that, but once again it's very much up to what the investor's mindset is. Some companies do have higher dividend yields, sometimes even reaching up to 10% - in those cases, the scenario becomes more attractive.

What are Special Dividends?

A rare corporate action that sometimes happens is for a company to issue a special dividend. This is a dividend that is one-off and is normally to reward shareholders following an influx of cash to the balance sheet. Alternatively, a special dividend may be announced if the company has excess cash on it's balance sheet. In any circumstances, these dividends can be significant.

An example of one of these was completed by Oil and Gas producer, Cairn Energy (LSE:CNE) in early 2012. Following the sale of a stake in its subsidiary, Cairn India, the company announced that it planned to return a massive £2.25bn to shareholders. That equated to around 160p a share which was huge when compared to its circa 280p share price at the time.