In this series, Todd Wenning, lead advisor for The Motley Fool U.K.'s Dividend Edge newsletter, takes a closer look at dividends and how you can use them as part of your investing strategy. This article has been repurposed from Fool.co.uk.
What is a dividend?
Simply put, a dividend is a portion of a company's profits that is returned to shareholders, usually in the form of cash.
It's a basic definition, but it's also a critical one to understand because dividends can play an important role in your total returns from a share investment.
Two sides of a coin
When you buy a share of a company, your ultimate return is generated by two factors:
- Capital return -- The overall change in share price from the time you bought to the time you sell.
- Income return -- The amount of dividend income you've received, if the company pays a dividend.
When many people begin investing, they tend to focus on the capital return part of the equation -- that is, the change in share price.
It's easy to see why that's the case. After all, the income return may start out small -- say, 2%-4% per year at first -- and that can seem trivial to some, compared to the potential big share gains we tend to hear more about in the news.
While the change in share price over time is indeed important, the capital return is only realized when you sell the investment. To illustrate, you can have a share that's quadrupled in value since you bought it, but you won't be able to use those gains to buy a sandwich or pay bills until you sell the share and convert it to cash.
Dividends, on the other hand, provide real returns whenever they are paid -- typically quarterly or semi-annually. You can cash the dividend check the company sent you and actually buy a sandwich or pay your bills. Even better, you can use the cash to buy more shares of the stock you already own to potentially accelerate your returns. (More on that later in this series.)
More to the story
Over time, those periodic dividend checks can add up -- a 2002 study by Elroy Dimson, Paul Marsh, and Mike Staunton found that between 1900 and 2000, both U.S. and U.K. market-oriented portfolios including reinvested dividends would have generated nearly 85 times the wealth of the same portfolio that relied solely on capital gains.
None of this is to say that we all have 100-year time horizons to let our returns compound, but it does show that dividends can play an important role in your long-term returns.
To see how this works, let's consider an example.
An investor who purchased 1,000 pounds worth of National Grid
At the time, National Grid shares traded for 372p and paid 12.49p in dividends, so the "yield" on the shares was 3.4%, which we get by dividing the annual dividend by share price (12.49p / 372p).
Fast-forward to today and over that twelve-and-a-half year period, the investor's return would have broken down as such:
| Type | Return | % Return |
|---|---|---|
| Capital | *727 pounds | 72.7% |
| Income | 770 pounds | 77.0% |
| Total Return on 1,000 Pound Investment | £1,497 | 149.7% |
*Based on share price of 5.61 pounds, as of December 20, 2010. Adjusted for rights issue but does not include reinvested dividends.
In this case, the income return has outperformed the capital return, even though the initial yield was just 3.4%. They may seem inconsequential at first, but dividends can be very important to a long-term investor's returns.
What's next
In the next article on Tuesday, we'll examine why companies pay dividends in the first place.
And if you'd like more help finding great U.K. dividend shares, consider a free 30-day trial of The Motley Fool U.K.'s new Dividend Edge service, where we aim to use our 20,000 pounds of starting cash to assemble a portfolio of quality dividend-paying shares. To learn more about a free trial, click here.
Todd does not own shares of National Grid, which is a Motley Fool Income Investor pick. The Motley Fool has a disclosure policy.
