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Shares Magazine
Every month in these pages AJ Bell’s Head of Markets Dan Coatsworth takes you through different facets of income investing. Generating an income from the stocks and funds you hold is a big part of why many people put their money to work in the stock market.
That’s because stocks do not just offer the ability to make gains when share prices go up – they also offer the prospect of income from the dividends they pay out.
The power of dividend reinvestment
You may want to take this income to help meet specific day-to-day expenses but, alternatively, by reinvesting this income investors can tap the full potential of the markets and not just protect their wealth but also create the possibility of giving it a major boost.
The power of compound interest was described by Albert Einstein as the eighth wonder of the world. How does it work? Well, if you put £1,000 into an account which pays interest of 6% you’ll have £1,060 after one year. Next year, you’ll be earning 6% on the £1,060 rather than just the original £1,000.
That might not seem like a big deal, but the effects can really stack up over time. How does this concept apply to the dividends from shares? A company’s dividend yield is calculated by dividing its full-year dividend per share payment by its share price. In many ways this yield is similar to an interest payment – offering a return which is proportional to your holding.
The difference compared to interest payments is that by reinvesting the income you’ll be steadily increasing your level of holdings and setting yourself up for even greater returns down the line. This effect is magnified if the level of income paid out by an investment is also growing. A topic we’ll return to later in this article.
The Barclays Equity Gilt Study 2025, an annual piece of research which provides a useful benchmark of returns from different types of investment, shows that if you had put £100 in UK stocks in 1945 and reinvested income you would be sitting on £326,231 as at the end of 2024 compared with £11,570 if the income wasn’t reinvested.
The big dividend questions
1. Are dividends guaranteed
No. They is no obligation for any company or fund to pay you dividends; they are free to start paying and then scale back or cancel them in the future.
2. Why are they paid in the first place?
They are management’s vote of confidence in a company’s future prospects. They tend to be paid out of cash generated from operations that isn’t needed for investment in the business. A fund will have stakes in lots of different companies who may pay dividends, so it collects those payments as a shareholder and then distributes some or all of that cash to its own investors.
3. I want to buy a stock or fund to get its dividend – is there a cut-off point to qualify?
Companies and funds will publish dates in their financial results that specify the timetable for dividend payments. The ex-dividend date is the most important. This is the point at which the share price will adjust to assume the money had been allocated to the qualifying investors. You need to own the shares before this date to qualify for the dividend.
4. How quickly does the money get paid?
Payment periods vary from company to company, or fund to fund. Some will pay you the cash in a matter of weeks; others can take several months to distribute the money. The exact payment date will appear alongside the ex-dividend date in the financial results.
5. How often are dividends paid?
Again, the frequency is variable. The ‘norm’ is for companies to pay every six months. Funds are increasingly paying dividends on a quarterly basis; there are even some who pay every month. This is because their underlying investments will probably be paying dividends at different times through the year, so the fund scoops up what’s come in every quarter and then redistributes the cash to its own shareholders.
6. Are dividends always paid in cash?
Generally, yes. A few companies will also offer payment in new shares – known as ‘scrip’ – although these are becoming increasingly rare.
Balancing dividend yield with dividend growth
There are two main things to look for when it comes to dividends. One of those is the dividend yield but equally important can be the level of dividend growth.
Inexperienced investors might find it hard to comprehend why income growth might ever be preferable than income yield. However, high dividend yields are often the result of a falling share price. This can be a warning sign that something is wrong with the company or its end markets and therefore dividends may not be sustainable.
Strong share price performance means the yields offered by dividend growth companies may not be the most eye-catching but over time they could still prove excellent investments. The ability to consistently grow a dividend implies a stock is cash generative, shareholder-friendly and has consistent track record.
You can run a few checks to assess whether a company is able to sustain dividend payments. An excessively high yield such as more than 8% suggests the market sees the dividend as unsustainable and it is often proved right. Dividend cover – that is how many times the forecast dividend per share is covered by earnings per share – can also provide some insight.
Dividend cover of two times or greater offers some comfort. A dividend cover figure below one times implies the dividend will be paid out of retained earnings and/or debt. There are only so many times you can raid the corporate piggy bank or back-up funds before the money runs out.
Getting diversified dividends
Ultimately a dividend is paid entirely at a company’s discretion. Investors can limit the risk of being too heavily exposed to a dividend cut by investing in income funds. By doing so it you also benefit from the expertise of the fund manager who can do the research to check the income stream from an individual company looks sustainable (albeit at a cost).
Investment trusts are particularly good at delivering dividend growth and consistency in that growth thanks to a structure which allows them to hold back income from bumper years to cover them in leaner years.
Industry body the Association of Investment Companies compiles a list of ‘’Dividend Heroes which have increased their dividend every year for the last two decades. Some can trace their dividend growth streak all the way back to the 1960s. However, these increases can be fairly piecemeal as having this status is a useful marketing tool.
To provide a greater level of insight, the table ranks these Dividend Heroes by their annualised dividend growth.
What about share buybacks?
There are two main ways a company can return cash to shareholders. They are dividends (either regular or one-off ) and buybacks. Typically, once a firm has purchased its own shares they are cancelled, thereby reducing the number of shares in issue. The positives to take from a buyback is they can be more tax efficient for shareholders assuming they would prefer to be taxed on a capital gain than the income from dividends, if you opt to retain your shares you will have an enhanced stake in the company and will be liable for more dividends in the future (if they are paid) and finally it implies the management team of a company, rightly or wrongly, believe the shares are undervalued.
Tom Sieber: Content Editor
Tom Sieber is AJ Bell's Content Editor. He was previously the Editor of Shares Magazine. He has been with the business since 2012.
Tom is a regular contributor to the AJ Bell Money & Markets...
