What the heck is a dividend?
Last week, the supermarket giant Tesco announced that it would resume paying a dividend to shareholders. Markets welcomed the news, but just what is a dividend, why is it important and which companies are the best dividend payers out there?
A successful company should be making enough money to pay its staff, invest in expansion, pay its taxes and hopefully have something left over at the end. Whilst it’s often sensible for companies to build up a cash pile to cover the unanticipated invoice that doesn’t get paid or the piece of machinery that needs replacing earlier than was expected, it is however seen as bad practice to just keep letting any cash surplus grow forever. As such, companies typically pay a dividend to their shareholders, allowing those who have taken the risk of investing their money in the business to gain a benefit, which comes on top of the hopeful capital appreciation in the share price.
Dividends can provide vital cash for those investors who are looking to generate a steady income Some companies - like Royal Dutch Shell - have dividend policy very much at the heart of their business and are currently paying a 6.4% dividend yield - so for every £1000 you own in Shell stock, you will get £64 in dividends. This becomes a virtuous circle as maintaining a commitment like this helps Shell keep its own share price up as investors really want the certainty of the cash. Obviously, there are risks - if the price of oil collapses again, or a miracle new energy source is found tomorrow, the share price might tumble, but for now most investors seem happy enough with the arrangement.
However, if you don’t need the income, the best thing to do with dividend payments is to reinvest - use the cash you get to buy more shares. Since the 1st May 2012, the FTSE-100 has risen by around 40%, but if you were to have reinvested all the dividends paid by these companies over the same time, your portfolio would have increased in value by over 70%. Tax laws change frequently, but currently UK taxpayers pay no tax on the first £5,000 of dividend income.
So where do you find good dividends? The research company Morningstar produces a regular update of the shares with the highest dividend yields. Their latest report from June can be seen here but shows Petrofac as the best payer, offering a 13.6% dividend yield, followed by Talk Talk Telecoms at 9.1% and Carillion at 8.9%. But just because a company pays a big dividend against a low share price doesn’t always make it a good investment. The dividend yield will look at what has been paid in the last year, whereas a share price is the market’s expectation of a company’s value in the future.
So, if a company has seen its share price fall sharply in recent months, the dividend yield may look brilliant today, but it’s what is typically known as a ‘dividend trap’. Be careful not to get caught!