LONDON -- Dividends can make a huge difference to your investment returns. Yet many investors do not understand their true power or meaning. Indeed, getting a grasp of dividends can help you avoid losers and back long-term winners instead.
1. Dividends can rise or fall
The dividend paid by a company to its shareholders can fall or rise from one year to the next. Dividends are never guaranteed.
A good example of this comes from BP
This progress came to a halt in the aftermath of the Deepwater Horizon disaster in the Gulf of Mexico. BP's dividend for 2010 was cut to just 4.3 pence per share. Since then, the payout has been increasing. For 2011, BP paid out 18.2 pence per share. Analysts forecast that BP will pay 20.6 pence for 2012, followed by 22.3 pence in 2013.
Investors have to decide whether a dividend can be sustained by the company's future profits. In BP's case, the company's future in Russia will be vital in determining the size of dividends in the long term.
2. Dividends can be tax-free
If you hold your shares in a self-select ISA, then any dividends you receive will be free of any further tax. Even if you withdraw the dividends to your personal bank account, there is still no further tax to pay.
In the U.K., basic-rate taxpayers generally don't pay any further tax on the dividends they receive -- unless their dividends take them into the higher-rate bracket.
3. Dividends are a huge part of overall investment returns
Investors often dream of buying shares and seeing the price double, triple, etc. What they often don't realize is how dividend payments can have a significant effect on ultimate returns.
If you invested 1,000 pounds in a portfolio that tracked the FTSE 100 20 years ago, the shares would today be worth 4,617 pounds with dividends reinvested. However, if you had spent all the dividends you had received, that 1,000 pounds would today be worth 2,305 pounds -- about half as much.
Large companies often run dividend reinvestment plans. Shareholders who opt into these plans receive their dividends in the form of shares in the company instead of cash.
Oil giant Royal Dutch Shell
4. Dividends are not necessarily paid twice a year
Most companies pay their dividends twice a year, with the second payment often being double the first. However, there are some shares that pay dividends quarterly, such as British Land
British Land has already paid three dividends during 2012: 6.5 pence per share on Feb. 17, a further 6.5 pence on May 9, and 6.6 pence on Aug. 10. On Nov. 9, the share will pay another 6.6 pence.
Broker forecasts for British Land indicate dividends of 29.6 pence per share for 2013, followed by 30.4 pence in 2014. Against today's price, that puts British Land on a prospective dividend yield for 2013 of 5.4%.
5. Dividends are anticipated by the market
If you buy shares on or after a certain date, you will not be entitled to the most recently declared dividend. This date is called the ex-dividend date.
At this point, the company's share price will often fall. It may, of course, fall more or less than the actual dividend payment due to factors in the market on that day. For companies that pay very large dividends, the ex-dividend date can result in a significant share-price fall.
6. Dividends are protection against a 100% wipeout
Even if a share has been on a storming run, if the underlying company subsequently goes bust, then the investment is worthless. However, if the company had been paying dividends along the way, then a shareholder could not suffer a 100% loss.
Consider ASOS and Gulf Keystone Petroleum, both of which have been phenomenally successful businesses. ASOS was an Internet fashion trailblazer that stayed ahead of its competitors and built a dominant position in its markets. Meanwhile, Gulf Keystone Petroleum has made huge oil finds in Kurdistan that have seen its shares rise from 13 pence to more than 200 pence today.
Despite the stonking rises these shares have delivered, neither company has ever paid a dividend. So investors in both outfits could (in theory!) still end up with a 100% loss.
7. Dividends are a signal
A company's dividend is often taken as a sign of management's confidence in the company's long-term profitability. A significant dividend rise can often lead to a rerating of the shares.
Recently, online gambling operator 888 Holdings stated it was to restart dividend payments. Since the announcement, the shares are up nearly 50%. Not only does the introduction of a dividend imply that the underlying company has become more dependable, but the share may also attract those investors who refuse to buy without a yield. Analysts now expect 4.1 pence per share in dividends from 888 for 2012, rising to 4.2 pence for 2013.
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David does not own shares in any of the above companies. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.