Chapter 11: Dividend investing

Posted on  By Phil Oakley

Updated: August 2024

If you are watching or listening to the news at the end of the day you will usually be told what happened to the stock market that day. More precisely, you will be told whether it went up or down in price.

Yet investing in shares is not just about changes in prices. When you own a share of a company you are often paid a dividend as well. Dividends can be very important. They can form a major part of any long-term savings plan and also a source of income to live on.

In this chapter, we are going to look at why dividends are important and how you can use them to build up your savings pot or as a source of income. Then we will look at some of the tools that ShareScope has to help you find some dividend paying shares that can help you meet your goals.

What are dividends?

Dividends are your share of a company’s after-tax profits paid to you during a year.

They make up part of the investment return from owning a share. However, unlike a share price that goes up but then goes down again, a dividend once it has been paid cannot be taken away from you.

What’s good about dividends is that they represent a real, tangible return on the shares that you own.

The same cannot be said for a rising share price. Share prices tend to move up and down a lot and there’s no guarantee that you will sell for a profit.

The return from earning a share

Return = Change in share price + dividends received

Investing in shares that pay chunky dividends and holding them for a long time can be a great way to build up your portfolio’s value.

That’s because the dividend from shares and the reinvestment of them is where the real money can be made from the stock market over the long haul.

Why is this?

Dividends and the magic of compound interest

I’ve never been able to find the source, but Albert Einstein was rumoured to have said that “the most powerful force in the world is compound interest”.

When it comes to investing – and dividend investing in particular – I’m inclined to agree with him.

Compound interest is essentially earning interest on the interest that you’ve already been paid. This is what tends to happen if you leave money in a savings account for a number of years.

Let’s say that you put £100 into a savings account that pays interest of 10% per year at the end of the year.

You have a choice of what to do with the interest that you receive. You can either spend all or some of it or you can reinvest it.

In the first year, you will receive £10 of interest on your £100 of savings. If you spend the interest every year, this is what happens to your interest income and savings over five years.

Year	1	2	3	4	5
Starting Amount	£100	£100	£100	£100	£100
Interest at 10%	£10	£10	£10	£10	£10
Spent	-£10	-£10	-£10	-£10	-£10
Ending Amount	£100	£100	£100	£100	£100

You receive £10 every year to spend and at the end of five years the value of your savings is still £100.

You’ve had £50 of interest income and preserved your savings pot. So your initial £100 has given you £150 of value.

But what would happen if you didn’t spend the interest and reinvested it back into the savings account at 10%? If you compound the interest you receive.

Year	1	2	3	4	5
Starting Amount	£100	£110	£121	£133.10	£146.41
Interest at 10%	£10	£11	£12.10	£13.31	£14.64
Spent	£0	£0	£0	£0	£0
Ending Amount	£110	£121	£133.10	£146.41	£161.05

Well, after five years, the value of your £100 would have grown to £161.05 and your annual interest income would have grown to £14.64.

The longer you reinvest your income the bigger the potential annual income and the value of your savings pot. This is the power of compound interest at work.

The one big caveat here is that the interest rate has stayed the same for five years.

This might be the case with a fixed term savings account or a bond, but is rarely the case for other investments. I’ll say a bit more on the effect of changing interest rates a little later on.

You can use this strategy of compounding to very good effect with dividend paying shares.

Instead of spending the dividend you receive, you use it to buy more shares in the company which paid you, which in turn gives you more dividends in the years ahead.

Repeat this process for long enough – the longer the better – and it is possible to turn a small initial sum of money into a large one. This can be the case even if dividends per share or the share price do not change.

Let me show you how this can work.

Let’s say that you buy 1000 shares in a company called Bob’s Book Stores plc at 100p per share (so an investment of £1,000) when it is paying an annual dividend per share of 4p.

Over the next thirty years the company doesn’t grow its profits but maintains them.

Dividends stay at 4p per share and the share price stays at 100p.

If you had kept your 1000 shares you would have received an annual dividend income of £40 (1000 x 4p) or £1200 over thirty years.

With your 1000 shares still worth £1000, your investment value would be £2200 (£1,000 + £1,200).

But if you had reinvested the dividends and bought extra shares (To keep things simple, I’ve ignored the impact of broking commissions and buying whole shares here) each year you’d have ended up with a much better result.

At the end of thirty years you would own 3243 shares worth £3243 and have an annual dividend income of £125. This equates to a yield on initial cost of 12.5% (£125/£1000).

An investment of £1,000 in Bob’s Book Stores over 30 years:

	Left alone	With dividends reinvested
Value of shares	£1,000	£3,243
Income Received	£1,200	£0
Investment value	£2,200	£3,243
Annual income in year 30	£40	£125
Yield on cost	4.00%	12.50%

That said, if you pick the right investments you’ll find that dividends don’t stay the same for thirty years – they can often increase substantially.

This makes dividend reinvestment and the power of compound interest even more attractive – if you can find the right share at the right price. More on this in a short while.

It’s worth adding that companies which have an explicit policy of paying and growing dividends (known as a progressive dividend policy) usually aim to increase their payouts by at least the rate of inflation every year.