People talk a lot about dividends but what are they, how do they work and how can you use them to guide your investment choices?

If a company makes a profit it can decide to keep money for future growth plans, to build a war chest, create a cash buffer in case of a downturn, invest the money, or it can pay that money out to shareholders in the form of a dividend.

An investor has two ways to profit from buying shares in a company:

-The share price can grow over time.
-The investor can receive dividend payments.

For many investors in the stock market, generating passive income is the goal and it is the second of these sources that motivates their investment.

When deciding which stocks to buy it is important to consider the dividend yield. Simply put, this measures the current annual dividend payment divided by the current share price. For example, at the time of writing Vodafone has a dividend yield of 6.01%. This means by investing £100 into Vodafone the investor receives £6.01 each year.

In contrast, the London Stock Exchange (yes, you can invest in the London Stock Exchange itself!) has a dividend yield of 1.40%. So investing £100 in the LSE would net the investor £1.40 in income each year.

Why such a big difference between two well known and well regarded FTSE companies? The answer is that the dividend yield is a single number reflecting a range of different factors.

If a company is more profitable, it can afford to pay higher dividends. However, if a good quality company pays a high dividend then more investors buy the stock, driving up the price, and driving down the yield. So the dividend yield is a measure showing how much demand there is for a stock relative to its ability to pay dividends.

In essence, a higher dividend yield means there is lower demand for the company’s shares amongst investors. This can be because the investors have analysed the market and doubt the company’s ability to maintain its current dividend payments.

A lower dividend yield, in contrast, typically means there is high demand for the company’s shares and this usually means investors regard the stock as extremely low risk.

Another factor to look at when deciding which share to buy is whether a company has a stable and increasing dividend over many years. This signals the company’s ability to consistently manage its finances, and its attitude to rewarding investors. The expectation may be that further rises are expected in subsequent years.

An investor should also look at the company’s Earnings Per Share (EPS). This number shows how much the company earns per share issued and a higher number is better.

Similarly, the dividend cover ratio which is the company’s earnings divided by its dividend payments. Again, a higher number is better because it demonstrates the company’s ability to pay its dividend and is an indicator of its ability to sustain its dividend in subsequent years.

There are many other factors to consider when analysing company dividends but these are some of the main factors.

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Capital at risk. Past performance is not indicative of future performance. This information is for educational purposes and does not constitute advice nor a recommendation.