Table of Contents
Can you Live Off of Dividends?
What Are Dividends?
First and foremost, the word dividend is derived from the Latin word “dividendum,” which means “things to divide.” Dividends are the part of a company’s profit that it chooses to share with its shareholders. This is an additional way of earning from an investment besides selling the shares. The amount of profit depends on the amount of stock the investor holds. It can be paid on an annual basis, monthly basis, quarterly basis, or semi-quarterly basis.
Dividends are special incentives paid to the investor to ensure that the company they have invested in is profitable. It aims to show that the probability of earning well in the future is high. In some companies, the investors have a special tax status. However, not all companies pay dividends; some choose to reinvest the profit into the company to earn more. So, if you want to earn dividends, you have to search for the companies that actually offer them.
Some companies choose to pay dividends in the form of cash, cheques, or just transfers into the bank accounts of shareholders. Meanwhile, others prefer to pay them in the form of estate or more shares in the company. The company’s board of directors usually determines the amount of the dividend. However, they usually first communicate with investors and confirm it before making the official announcement.
In this article, you will learn in-depth information about dividends, how they work, and the advantages associated with them. Happy reading!
Types of Dividends
Although some of them are not really common, there are several types of dividends other than regular dividends.
A cash dividend is the most common type of dividend. With this dividend, the company pays the dividend profit amount to the investors in the national currency of the firm or through a bank transfer or cheque. Cash dividends are usually taxable for the recipient that he/she has to pay within a year.
Special dividends greatly resemble regular dividends. Companies pay these, too, on the basis of the common stock that you own. However, they are “special” because companies pay them after several years when they decide to distribute the accumulated profits to their investors.
As the name suggests, preferred dividends are the dividends paid over the preferred stock. The preferred stock is the stock that works like a bond and has a fixed dividend amount. The preferred stock has priority over the regular stock with this dividend.
Companies pay out this kind of dividend to shareholders in the form of new shares in the company. The company determines the number of new shares on the basis of the already owned number of holdings.
The company does not only pay dividends in the form of cash, but they also pay them out in the form of real estate. The company can also pay in the form of investment securities, physical assets, and property. This is not a common practice, though.
Dividends as a Passive Income
The income you obtain in the form of a dividend is totally passive in nature. For those who do not know, a passive income is the earnings derived from a business in which you do not take an active involvement. An example is the rent of a home that you have rented out, limited partnerships, etc. By taking the time and making a profitable decision, you become a minority owner in a business with no direct involvement in business-related matters.
A dividend increases your income and helps you cover your retirement goals. You can even live off your dividends, not on an immediate basis but with a good plan and strategy to achieve that status. If done right, the investor’s monthly income and the household income can increase rapidly. You can use this amount to send a child to college, start a new business, for funding, for charity purposes, or even for a good, healthy vacation.
Dividend on Investing
The most common way of receiving a dividend is by investing in a company. Here, investment means purchasing the shares of the company that can provide the most profit. The investors invest an amount and receive a dividend based on that invested amount/shareholding. Dividend investing is a kind of growth and value investing, where you either hold on to a faster-growing company or hold on to the cheaper companies with the hope of achieving long-term share price growth or benefits.
Advantages of Investing in Dividend Paying Companies
A few of the main perks and benefits that investors enjoy upon investing in dividend-paying companies are:
- One significant benefit is that the amount of the dividend that companies pay to investors slowly grows over time. Large and established companies increase this amount every year. It happens very rarely that any dividend-paying company stops paying it.
- Although there is a market risk of the stocks going up or down at any time and the profit over the investment is not always guaranteed, partial return on the dividend stock is almost guaranteed.
- Also, the dividend yield of the dividend-paying companies is comparatively higher than any other fixed-income investment.
- Dividends greatly help in the equity evaluation or selection of the stock. They change only once a year and do not face frequent fluctuations.
- Dividends decrease portfolio risk and fluctuations. The dividend amount neutralizes the effect of any loss on the stock price.
- Dividend-paying stocks perform better than non-paying dividend stocks. Hence, they face a lesser decline in the value than the stocks that do not pay a dividend.
- There are certain tax benefits on the dividend amount. There are significantly lower tax rates on this passive income in comparison to ordinary or direct income.
Why Pay Dividends?
Companies pay dividends for several reasons that include retaining and attracting potential investors. It can help maintain a relationship of trust and favor between the company and the shareholder. If the company pays the dividends, investors may view its shares and think them to be superior to the competitors.
Companies also pay dividends to increase the wealth of the shareholders. Subsequently, this will lead to benefit for their own company. The bolster in the wealth of the investors will lead to more trust and eventually to more purchases of shares.
If a company stops paying the dividend, it could be an indication that the business is facing trouble. If the company starts cutting the dividend amount, it could be a sign that the company is investing or looking for other ways to increase the returns of the investors. Likewise, if the company pays dividends on a regular basis, it could be a sign that the company does not have other ways of generating returns, which is why they do not reinvest their capital.
Dividends in the UK
In the UK, the amount of dividend and the number of times companies pay it depends upon the individual company. Usually, the dividend amount depends on the total profit of the company. However, some companies, for the sake of maintaining favors from the shareholders, pay dividends from their accumulated wealth even if they do not make any profit. It is compulsory for a company in the UK to pay all their taxes and expenses before paying the dividends.
Depended on the dividends, the company usually pays the amount on two dates. The final dividends are paid at the end of every financial yearly, and interim dividends are paid on a fixed basis – monthly, semi-quarterly, or quarterly.
The company does not have to pay any taxes on the dividend amount it pays. However, the shareholder who receives the payment has to pay a tax on the received amount. But the payment of the tax is mandatory only when the income falls in your personal allowance (when the dividend amount is £2000 and above).
What Is a Dividend Yield?
A dividend yield is the measure of the proportion of a company’s dividend compared to the price of its shares, expressed in the form of a percentage. Investors should always keep an eye on the dividend yield of a company and compare it to that of the competitors in the same industry before making a decision to invest their amount. A higher yield indicates a lower share price and unsustainable dividend payments.
The company’s dividend yield is directly proportional to its dividend amount and inversely proportional to its share price. So, if the company’s dividend price increases, the dividend yield also increases. On the other hand, if the share price of the company decreases, the dividend yield automatically increases. Similarly, if the company’s dividend amount decreases, the dividend yield also decreases. Furthermore, if the share amount increases, the dividend yield decreases.
Dividend Payout Ratio
The dividend payout ratio, also known as the payout ratio, is the proportion of the total dividend amount paid to the shareholders compared to the total income of the company expressed as a percentage. The company uses the amount left after paying off the dividends to reinvest in the important operations or pay off debts.
It is a comparison of how much wealth a company is returning to the shareholder versus the wealth the company is using to reinvest in itself, pay off the debts, or add to the reserved earnings.
Dividends and Compounding Wealth
The dividend amount paid by the company can be reinvested and result in an increase in the size of the holding. The name given to this phenomenon is compounding wealth. The advantage of compounding wealth is that the return will not only depend on the capital growth of the initial deposited amount but also on the dividend that accumulated while the investment opportunity was open.
For example: If an investor invests £1000 on shares worth £5, he owns 200 shares (1000/5). The investor earns a 20p dividend per stock, so he earns a total of £40 on his investment in the first year. Now let’s assume that the share price increases by £1 each year, and the percentage of the dividend remained at 4%. Therefore, after ten years, the investor will get £760 from dividends and own shares worth £2800 based on the calculation (£14 x 200 shares). The total on the investment becomes £2560 – £1800 share price plus £760 dividend.
If the investor had invested the money they earned from the dividends, their final investment amount would have doubled or tripled with every passing year. Hence, the final return on the investment would have been above and beyond the share price growth.
Advantages of Compounding Wealth
- Reinvestment is automatic and is easy.
- You will not have to pay the commission or brokerage fee when you buy more shares with reinvesting.
- The process is consistent; you will automatically get more shares without any additional effort.
- Some companies also allow you to buy stocks at a discounted rate.
Can You Get Rich From Dividends?
This is one of the most frequent queries that a person may have. He may not ask someone but might think about it. The answer is yes; an investor can undoubtedly become rich from dividends. As long as the investor maintains strict discipline, stays time conscious, and makes good investment decisions, a person can become rich. Also, the concept of compounding wealth can account for an increase in wealth just from reinvesting the dividend.
A dividend is an assigned amount of the company’s profit paid to the shareholders to maintain a relationship of trust and understanding. When dividends are paid, the share price of the company decreases because the company is already spending a portion of its revenue on paying dividends. Shareholders can either receive the payments or reinvest that into the company to get a bigger and more profitable advantage in return.
The investment in the stocks of the dividend-paying companies is substantially profitable. It carries many advantages, including low tax rates, growing profit or dividend amount every year, reduced market risk, and additional income. Furthermore, it faces significantly lower fluctuation if a stock goes down and helps protect the capital’s purchase power.