- Investing in dividend stocks is a great way to generate a stream of stable income.
- Although higher dividend yield is considered favourable, dividend yield traps must be avoided.
- Dividend income may also get taxed.
Dividend stocks or dividend yield stocks are the stocks of the companies which pay regular dividends to investors. When investors purchase shares, they become partners to the profits that are generated by the company through its business activities. The company has a choice to either reinvest its profits for future growth and expansion or distribute a certain proportion of it among the shareholders. Dividends are the profits that are distributed by the company among the shareholders, and it is a great source of regular income via stock investments.
Why to choose dividend stocks
Although dividend payments may appear to be insubstantial in the short term, they can potentially make up a significant proportion of the total returns from your stock market investments in the long term. For example, when the dividends were not taken into account while calculating the returns, the FTSE 100 index returned only under 15% for the 10-year period to the end of 2016, while the total returns jumped up significantly to 67% when the reinvested dividends were also taken into account in the same period.
Also read: Top five high dividend-paying FTSE stocks
The ability to create a sizable passive income stream is also a great advantage associated with dividend stocks. This income can be reinvested to generate more income, and this process of compounding can lead to the growth and development of the investor’s portfolio.
Dividend stocks can also protect the investors during the times of market volatility, as they tend to fall less than growth stocks during these periods. In volatile periods, the investors are attracted towards the companies that pay dividends, as they are usually have very sound and well-built track record and are also quite established to live through the volatile period. Although it is important to keep in mind that past performance doesn’t necessarily give reliable insights about future performance, and the income derived from dividend stocks may go up as well as down.
Avoiding the trap
Dividend stocks have many advantages, but they can prove out to be risky investments if the investor isn’t aware of what to avoid. There are a lot of potential candidates offering dividend stocks in the UK, but some companies offer more dividends than others based on a range of factors. Thus, it is important for the investor to carefully choose dividend stocks and create a diversified portfolio to minimise the risk.
Also read: Top 10 AIM Stocks with Dividend
The metrics that are used to evaluate the reliability of dividend stocks include dividend yield, payout ratio, cash dividend payout ratio, total return, EPS (earning per share), and P/E ratio. The dividend stocks with high yield are considered as good investment options, as higher dividend yield signifies a higher annual dividend. Dividend yield is the ratio that helps the investors evaluate the amount of dividend that the company pays out in comparison to its stock price. But a higher dividend yield doesn’t necessarily mean that the stock is better, as the ratio is subject to the falling stock price while can in turn increase the dividend yield. It is, thus, very important to first analyse the reason behind the fall in stock price, or else investing in such stocks can prove to be counterproductive. Therefore, the investors should consider two major factors before investing in dividend stocks. Firstly, the company should have a consistent track record of paying dividends, and secondly, the dividend yield should be consistently rising every year.
High yield isn’t everything and the dividend yield traps must be avoided by keeping in mind that higher dividends may not often be a sign of opportunity, but of trouble. The yield can be high even if the company isn’t doing well and is in danger of cutting its payouts. Payout ratios must be used to assess the sustainability of the dividend, and they can be calculated by dividing DPS by EPS. The dividend history of the company and its dividend cover should be used as a guide to assess the yield as well as the payout growth. The dividend cover can be calculated by dividing earnings per share (EPS) with its dividend per share (DPS), and a value of 2 or above is considered as safe, but a value below 1.5 is considered risky.
It is also very important to study the balance sheet of the company and analyse its financials such as cash flow, debt, assets etc. Having more cash on the balance sheet enables the company to pay out higher dividends. To sum it up, more gap between dividends and earnings theoretically implies that the company is more capable in paying out dividends even if its profits take a hit. The company as well as the industry should be researched before investing, and investments should be made considering the future growth prospects.
Tax on dividends
Contrary to dividends from foreign companies, generally there’s no tax deduction in dividends from UK companies at source. At present in the UK, the first £2,000 of dividends is free from any tax payment, which is the dividend allowance. Depending on your income tax band, the amount of tax to be paid on dividends over and above the dividend allowance is decided. For the basic rate tax band, the tax rate on dividends over the allowance is 7.5%, for higher rate it is 32.5%, and for additional rate it is 38.1%.
Also read: Does FTSE 250 pay dividend?
Under the foreign rules, any tax deducted at source may lead to a reduction in the UK tax payable under UK rules. There’s no tax on dividends in case oh holding shares in an ISA or a pension plan, and the deductions can be reclaimed at source.
There are a lot of factors and parameters to consider while assessing the strength of a company or its stocks. Thus, before investing, it is important for the dividend investor to conduct a meticulous research to understand the financial status, competitive standing, growth path and management efficiency etc. of the company. The investor’s portfolio can grow immensely by adding high yield dividend stocks to it, but it is necessary to ensure the reliability of the stock and avoid buying stocks while only considering higher dividend yield.
Also read: Which FTSE shares pays the best dividend?