What are Dividends?

Back to School Week: What are dividends and how can they help investors? Guest host Samuel Kemp speaks to Morningstar analyst Jon Miller 

Holly Black 9 September, 2020 | 11:10AM
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Holly Black: It's back to school week at Morningstar and to help cover all the investment basics we have brought back our team of young experts. Luckily, they are as good at technology as they are at grilling our analysts.

Samuel Kemp: Hello. My name is Samuel Kemp. And today, I'll be talking to Jon Miller about dividends. Hello, Jon.

Jonathan Miller: Hi, Samuel.

Kemp: So, what are dividends?

Miller: So, dividends are what companies release to investors when they make profits. So, what that means is that if you own a share in a company, they might say that they're declaring a dividend because they've been happy with the profits they've made and they consider some future prospects and they might give you some money in return. So, if the share is worth £1, they might give you 5 pence as a dividend. Ultimately, it's part of rewarding shareholders who are backing that company and they can return some profits back to their investors, shareholders.

Kemp: Why do companies pay dividends?

Miller: Well, there's a few ways to look at it really. Because when companies generate a profit, so when they make money at the end of the year, they want to decide what to do with it in the future. So, they might say, we need to invest for future growth. So, we'll put some of that profit towards that. They might need to keep some money safe for a rainy day. So, they will hold that as cash. And then they'll say, right, we've got some excess money that we want to return to shareholders who have backed us over time. So, that's when they will declare the dividend, give that to shareholders. And it's also a way that managers, people that run the business can show to shareholders that they are strategically thinking about the direction and that with that excess profit, they can give some money to them and you can hopefully stay with them over the long term as well.

Kemp: Why do investors like dividends?

Miller: There's probably a couple of reasons for that actually. Let's start with investing at an early age. So, someone like you who's got a very long-term horizon, as and when a company pays a dividend, you may prefer to reinvest that by buying more shares in that business. I'd say a second reason why investors like them is that if you're more at retirement age, that dividend is an extra bit of cash in your pocket, let's say. So, when you're older and you've got – you might have healthcare to pay for, other expenses in retirement, actually you want to have generated a pot of money by saving over time into your retirement pot and then use that dividend as a way of funding your lifestyle.

Kemp: Can you get dividends if you invest in a fund?

Miller: That's a good way of thinking about it, because you're right, a fund holds a number of shares. So, what does a fund do in its portfolio when all those shares are declaring dividends or not? Ultimately, it's an average of the holdings in the fund that create the overall dividend. So, you don't forfeit anything by being in the fund. If anything, you can get a more diversified dividend stream given some companies do have ups and downs within a fund. So, it's a good way to think about a fund to invest with dividends as well.

Kemp: Thank you for your time, Jon. For Morningstar, I'm Samuel Kemp.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Holly Black  is Senior Editor, Morningstar.co.uk