Everyone loves money – and even better if it just comes passively. Property rental was the classic way but now there’s a new kid in town.
Enter dividends, a very popular income stream and already a staple of many an investor’s portfolio.
In this guide, we will give you the complete overview of dividends and detail the best ways to invest for dividends in a halal way.
Here’s the full list of topics that we will cover:
- What are dividends?
- What are the sharia compliance considerations?
- Why do companies pay out dividends?
- Is investing for dividends the right approach for you?
- How dividends are issued
- How often dividends are paid
- Do dividends affect the share price?
- Key factors to consider for dividend stocks
- Should you reinvest your dividends?
- Do you have to pay tax on dividends?
- Cash dividends vs stock dividends
- Dividend investing strategies
- What are the top sectors for dividend stocks?
- How can you invest in dividends?
What are dividends?
Dividends are payments made by companies from their profits to their investors.
There are three types of dividends:
- Cash dividends. This is the most common type of dividend where you receive a specified amount of cash per share you hold. You can then pocket this payment or reinvest it back into the stock. More on this later.
- Stock dividends. Instead of cash you get more shares. So if a company issues a 2% share dividend, you will then receive 2 more shares for every 100 shares that you own. Companies tend to go for stock dividends when they don’t have a lot of liquid cash on hand to pay out cash dividends.
- Scrip dividends. This is where a company offers to pay you a stock dividend instead of a cash dividend. You can then choose whether to receive your dividend in the form of shares or cash.
What are the sharia compliance considerations?
Receiving dividends is totally fine as they are just a share of the profits made by a company in which you have an ownership stake in. The only thing to watch out for is whether the underlying business itself is permissible.
For more detail on the screening criteria for companies, here is our stock screening article. We also have a halal stock screener course that goes into more detail and breaks down each step of the process.
Why do companies pay out dividends?
Companies usually pay out a dividend as they don’t have anything better to do with their profits. This is why most dividend payers tend to be big established companies whose high growth phase is behind them. Instead of reinvesting all of that generated money, they give a proportion of it to investors. It’s also a nice financial incentive for investors to invest in their company.
Most companies don’t pay out dividends. Some of them are yet to make a profit whilst others instead reinvest their profits into the business to pursue growth. That money could then be used for growth initiatives such as funding research and development or expansion projects.
Is investing for dividends the right approach for you?
There are two ways to make money when investing in shares.
Either the value of your shares becomes worth more than you paid for it (capital gains) or you receive a regular dividend from the company. For some stocks you can only make money through capital gains whereas for dividend stocks, it can often be through both dividends and capital gains. The key consideration here is whether you are investing for growth or investing for regular income.
Growth investors tend to stay away from dividend stocks as they are looking for companies that are still in their growth phase. These companies will be reinvesting most of their money to pursue growth initiatives and as such have the potential for larger capital gains.
Dividend investors want dividend stocks as they want the dividend payments and have a lower risk tolerance. As dividend stocks tend to be more established companies with a proven track record of success they tend to be less risky than growth stocks. As such the potential for capital gains is usually lower. This is fine as the aim for many dividend investors is to build a reliable dividend income stream. For example, a portfolio of £500k with a dividend yield of 4% could provide you with a tidy annual income of £20k.
How dividends are issued
When dividends are issued there is a formal process they go through. Here are the key dates you need to be aware of.
- Declaration/announcement date. This is the date when dividends are announced along with the ex-dividend date and the payment date.
- Ex-dividend date. To receive a dividend, you need to be holding shares of the company by the ex-dividend date. So any shares purchased on the ex-div date or after will not be eligible for a dividend.
- Record date. This is usually the day after the ex-dividend date and is essentially when the company checks to see which of its shareholders are eligible for the dividend.
- Payment date. On this day, the company distributes the dividends to each eligible shareholder. It may come a bit later if your shares are held in a nominee account with a stockbroker (e.g. AJ Bell). In that case the company pays the stockbroker who will then pass it on to you. Historically many dividends were paid by cheque but this is not so common now.
How often dividends are paid
Most companies pay out quarterly or even twice a year. Some even pay out monthly. Any dividend payments made throughout the year are referred to as interim dividends. At the end of the year, the last payment will be called a final dividend. Ultimately the payment schedule will vary based on the company. The total dividend yield will still be the same. The payment will just be spread out over the payment schedule with the final dividend typically being the largest payment.
On rare occasions, some companies will even issue a one-off special dividend. This could be because they have extra money they would like to distribute or in response to a major win by the company.
Do dividends affect the share price?
Yes. Usually, the share price drops by the equivalent of the dividend rate on the ex-dividend date. So buying a stock just for the dividend and selling immediately after is pointless.
Key factors to consider for dividend stocks
There are a lot of factors you need to consider when looking at dividend stocks. Here are some key considerations.
1. Dividend yield
The dividend yield tells you what the size of the dividend is relative to its current share price. For example, a company with a share price of £100 and a dividend yield of 5% will give you a dividend of £5 per share you hold.
Dividend yields are reported in two ways. Either they will be reported as the trailing dividend yield or the forward dividend yield.
The trailing dividend yield tells you what the dividend yield was for the previous year. The forward dividend yield is the predicted yield for the coming year. You need to be sure which yield figure you are looking at. Particularly as dividends aren’t guaranteed and can be cancelled, cut, or even increased. More on this later.
There is no rule of thumb answer to what makes a good yield. It depends on many factors. Beware really high dividend yields (~8%). A high yield may look initially attractive but it tends to be a good indicator that a company is in trouble.
A reason for such a high dividend yield could be because the company has recently had a big drop in price, so its historic dividend amount now looks like a much higher percentage of its total value. However, often, such companies will end up reducing their next dividend payments anyway.
Conversely a low dividend yield may initially look poor but could mean the company is prioritising growth which could be great over the long term.
A sensible range would be between 2% – 6%. 2% is close to the S&P 500 average in recent years and should therefore be the minimum you look for1.
2. Dividend history
Ideally you want a company with a long track record of regularly paying dividends. You may want to avoid companies that have a patchy history of paying dividends. That being said you might want to be flexible of dividend misses during crazy periods such as last year’s covid crisis. In that case paying a dividend whilst a business is in trouble may not be the best option for the company. However, often companies will do so to avoid disappointing their investors and maintain their payout streak.
Companies regularly reducing their dividend is a bad sign and could hint at future troubles. You want companies that ideally raise their dividend over time.
3. Dividend payout ratio
This tells you how much the dividend is relative to the profit. You work it out by dividing the total dividend by profits. So, if a company has profits of £1m and pays out a dividend of £100k, its dividend payout ratio would be 0.1.
This ratio can help you interpret how sustainable a company’s dividend is. If it’s a large ratio, then this could mean the company may struggle to continue paying the dividend if it falls on hard times. A low ratio could mean the company has ample room to potentially raise the dividend and not break the bank.
That being said, you shouldn’t look at the payout ratio in isolation. It should be combined with other information to allow you to make a more informed decision.
4. Dividend cover
This is the inverse of the dividend payout ratio and is another measure for how sustainable a company’s dividends are. This time you divide the total profits by the total dividends.
Revisiting our earlier example of a company, we see £1m in profits with a £100k dividend results in a dividend cover of 10. This is really healthy.
Any dividend cover less than 1 is a major red flag as it means that the dividend is unsustainable given it exceeds the profit. To be safe it may be best to stick with dividend stocks that have a cover ratio of at least 1.5.
Dividend criteria checklist
To summarise, you want a dividend stock that has:
- A dividend yield between 2-6%.
- A long track record of regularly paying dividends (and ideally increasing it).
- A sustainable dividend payout ratio.
- A sustainable dividend cover figure that is greater than 1.5.
Should you reinvest your dividends?
Once you receive your dividends, you have two options. You can either pocket the payment or you can reinvest it back into the stock. What you should do depends on your investing strategy.
If you are investing for growth, then reinvesting your dividends would be the better choice. This is because reinvesting dividends has historically led to better returns. Take a study looking at the performance of the S&P 500 between 1980 and 2019. It found that 75% of the returns came from reinvested dividends.
However, if your strategy is to use the dividends as a regular income stream then pocketing the cash is what you should do.
Do you have to pay tax on dividends?
This depends on your country of residence and whether or not you have invested through a tax-free wrapper such as an ISA (individual savings account).
For UK investors, all dividends earned from companies in an ISA are tax-free. Outside of that each individual has a tax-free dividend allowance of £2,000. Any dividend income earned above the £2k allowance in a non-ISA account will incur tax. The amount of tax charged depends on your income tax band. You need to add your taxable dividend income to any other income (e.g. your wage) you received in that tax year.
You then pay according to the tax band you fall under. For 2021-22 the tax rate on dividends over the allowance is:
- 5% for basic rate taxpayers
- 5% for higher rate payers
- 1% for additional rate payers
These rates will be increasing next year. For more information, check out the HMRC website. As you can see the tax rate can be pretty steep for dividends so make sure to utilise your full ISA allowances each year.
If you are investing in international stocks you may be liable for a withholding tax depending on the country of that stock. A withholding tax is charged by an overseas government on dividends received by international investors. This amount varies depending on the country and countries often have double taxations agreement in place to mitigate this burden.
For example, the US would normally charge a withholding tax of 30%. However they have an agreement with the UK government whereby UK investors don’t get taxed if the investment is in a SIPP (self-invested personal pension) and if not, a reduced rate of 15% is applied.
This is all taxed at source and handled for you by your stockbroker. If you have any further questions about this, it is best to reach out to your personal stockbroker.
Cash dividends vs stock dividends
We previously discussed the two main forms a dividend can take. Cash dividends are usually more common but in the event you are given the choice, which one should you take?
Cash dividends provide you with regular income and could align with your plan to use dividends as an extra income stream. Companies that issue a cash dividend will usually see their share price fall by the equivalent amount. Whereas companies that issue a stock dividend will see the total shares increase but your proportionate holding will remain the same. So, in the short term the value to you is the same.
An important consideration is that cash dividends are risk-free which is not the same for stock dividends. With stock dividends your additional shares will be tied to the performance of the stock.
So if the stock plummets after the you receive a dividend, you would have been better off with the cash amount. Conversely if the stock shot up, the stock dividend would have been the better option.
However opting for a stock dividend could save you money in fees. This is because with a stock dividend, you can obtain new shares without having to pay broker fees or stamp duty (for UK investors). Moreover, for cash dividends, you may be liable to pay tax.
So the choice depends on what your personal investing goals are. If you don’t want the immediate reward of a cash payment and are confident in the company’s prospects, then perhaps it would be best to take the extra shares and save on the resulting fees.
Dividend investing strategies
Buy and hold
This is the simplest strategy where you simply buy and hold. If you’ve invested in the right company the dividend yield should increase over time relative to your initial investment and could grow to be quite lucrative.
To bolster this strategy you could set up a regular investment to continue investing. This is a great idea if you are confident in your investments ability to continue performing.
Investing during market crashes
This is a great way to nab amazing dividends from solid companies at really cheap prices due to a temporary market crash triggered by exceptional events such as covid. This works as dividends are based on company performance and not the share price.
So if the share price has tanked due to a crash but the overall company is fine, it could be a great deal. The key here is to be sure that the crash in the stock price is only temporary and the stock has strong fundamentals that sets in good stead for the future.
We covered this in more detail in this article here.
The hybrid approach
You could mix your portfolio to include both growth stocks and dividend-stocks. This gives you some diversification and can help to moderate your risk exposure that you incur when investing in growth stocks.
It is also common for growth stocks to eventually mature into dividend paying companies once their growth stabilises. This could be a great strategy if you don’t need the dividend income right away.
You can start building up your dividend income stream and still achieve high growth in your growth stocks. This high growth can be converted into dividends that be quite a high yield with respect to your original investment.
What are the top sectors for dividend stocks?
The following 5 sectors are currently among the top sectors for dividend stocks:
- Consumer staples
- Real estate
They are all established industries that have companies with strong reliable cash flows. However these sectors just reflect the past landscape.
In the future you could see newer sectors such as technology emerge as strong dividend payers.
There are a few tech stocks that already pay dividends but for the most part the technology sector is still growing. When these newer sectors mature, they could be really compelling dividend options.
How can you invest in dividends?
DIY and invest in dividend stocks
The most direct way to obtain dividends is to invest in dividend-paying stocks. This is where you look for companies on the stock market that offer dividends to invest in by yourself.
However you are responsible for screening them to determine their halal status and also have to do your due diligence on the company’s prospects.
If you are an experienced stock picker or fancy your chances of going it alone, this could be a great option for you. If you manage to pick the right dividend stocks you could achieve a greater return than that of funds.
This is because funds typically have many holdings so to overperform they would need strong performance from many companies. Whilst you would just need a handful.
However you are more exposed to the risk of making a poor investment decision. For those that want a bit more support when investing, the following options will be more suitable.
Invest in dividend ETFs
Investing in dividend themed exchange-traded funds (ETFs) is a great low-cost way to get diverse exposure to a range of dividend stocks. Here the fund manager is responsible for selecting the stocks and because there is a diverse range, you are less affected by poor performance or dividend cuts and cancellations.
The main issue here is finding halal dividend ETFs. We cover this and more in our complete guide to ETFs.
If you don’t have a high risk tolerance and prefer steady investing that puts cash into your pocket, then dividend investing is the way to go.
Over time you could build up a tidy passive income stream that could become a route to financial freedom.
If you want to learn more about other areas of investing, check our Halal Investing 101 Guides.