Firms that make profits have two choices – they can either keep them and reinvest them in the hope of making more profits or pay them out to shareholders as a dividend.
Let’s say a firm makes profits of 10p per share, it might decide to pay out 2p per share as a dividend. This is cash paid directly to shareholders. The remaining 8p per share is reinvested in the business. For investors seeking regular income, dividend paying shares are better bets than non-dividend payers. The latter are known as growth shares and are higher risk in the sense that a shareholder’s gains all come from share price appreciation. There are two types of dividend – ordinary and preference – however ordinary dividends, which are determined by the directors each year, are the more common. Note that UK dividends are paid net of standard rate tax, so a 3.6% dividend yield is equivalent to 4.5% when stated gross (before basic rate tax).