Dividend stocks explained: how to generate income through shares

No idea what a dividend stock is? Here’s what you need to know.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

In the current low-interest-rate environment, many people are ditching their savings accounts and turning to other investments in an effort to generate higher returns on their money. ‘Dividend stocks’, which offer high levels of income compared to savings accounts, are one such investment. 

Don’t know what dividend stocks are? Don’t worry. Here, I’ll explain how they work.

What is a dividend stock?

A dividend stock is a share in which the underlying company pays out a proportion of its profits to shareholders, in cash, on a regular basis. These cash payments are called ‘dividends.’ It really is quite a simple concept to grasp – if you own a dividend stock, you’ll receive cash payments from the company (usually twice or four times per year) simply for being a shareholder.

Here in the UK, there are many dividend stocks listed on the London Stock Exchange. Examples include Royal Dutch Shell, Lloyds Bank, and Legal & General.

How much income do dividend stocks pay?

Every dividend stock has its own dividend ‘yield.’ This is a similar concept to an interest rate on a bank account. For example, if a stock has a dividend yield of 5% and you have £1,000 invested, your dividend will be £50 per year.

Dividend yield is calculated by taking the company’s dividend per share and dividing it by its share price. Looking at Lloyds, it declared a dividend of 3.21p per share last year and its share price is currently 61p. That means the dividend yield is 5.26% (3.21/61 = 5.26).

Other examples of dividend yields available right now include:

  • Royal Dutch Shell: 6.5%

  • Legal & General: 5.8%

  • GlaxoSmithKline: 4.6%

  • BT Group: 8.2%

Be careful with high yields

While dividend stocks can offer excellent yields, you do have to be careful with really high yields (7%+). That’s because companies with super-high yields are often experiencing problems. What’s happened is that a lot of investors have already sold the stock, which has pushed the share price down and the yield up. Quite often, these kinds of companies go on to cut their dividend, which isn’t what you want as a dividend stock investor.

What to look for in a dividend stock

There are a few things you should check before investing in a stock for its dividend. These include:

  • Dividend growth – ideally you want a company that has a consistent dividend track record and has grown its dividend over time

  • Revenue and earnings growth – this will help the company increase its dividend

  • Dividend coverage – this is the ratio of earnings per share to dividends per share. It gives an indication of whether the company can afford its dividend. Look for a ratio above 1.5

  • Debt – companies with high debt are more likely to cut their dividends in the future

Risks

Of course, as with any investment, there are risks associated with dividend stocks. It’s important to be aware that, due to the volatile nature of the stock market, you might not get back what you invested. Even if you pick up a 5% yield on a stock, you could still lose money if its share price falls heavily. Secondly, dividends are not guaranteed. A company can cut or reduce its dividend at any time.

Overall though, dividend stocks can be a great way to build up an income stream. Compared to savings accounts, they offer the potential for much higher returns.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Edward Sheldon owns shares in Lloyds Bank, GlaxoSmithKline, Royal Dutch Shell, and Legal & General Group. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Investing Articles

Here’s how I’d follow Warren Buffett to start building passive income in 2025

Ben McPoland highlights one FTSE 250 firm with a strong competitive edge that he thinks can continue rewarding investors with…

Read more »

Investing Articles

Burberry shares: undervalued FTSE gems that are ready to rocket?

Burberry shares soared at the beginning of the week as the takeover rumour mill went into overdrive. Is Paul Summers…

Read more »

US Stock

Here are the latest share price forecasts for S&P 500 giant Amazon

Amazon has generated monster gains for investors over the last decade. And Wall Street analysts believe the S&P 500 stock…

Read more »

Man writing 'now' having crossed out 'later', 'tomorrow' and 'next week'
Investing Articles

2 high-yield FTSE 250 shares I’d buy today — and 1 that I’d avoid

UK markets have felt some volatility after last week’s Budget and the FTSE 250 was no stranger to it. Our…

Read more »

Investing Articles

3 reasons the Rolls-Royce share price could soar over the next decade

Sustainable aviation fuel, narrow-body aircraft, and small nuclear reactors could all keep the Rolls-Royce share price climbing over the next…

Read more »

British flag, Big Ben, Houses of Parliament and British flag composition
Investing Articles

Here’s how much income I’d get if I invested my entire £20k ISA in cheap BT shares

BT shares are on the up but still cheap, while the FTSE 100 telecoms stock offers a good yield too.…

Read more »

Investing Articles

2 FTSE dividend shares yielding more than 6% with P/Es of less than 9!

Harvey Jones picks out two brilliant FTSE 100 dividend shares that yield more than 6% but are selling at strangely…

Read more »

Investing Articles

Up 105% in a year! Is this rocketing FTSE bank the perfect pick for my Stocks and Shares ISA?

Harvey Jones is drawing up a shortlist of stocks to purchase inside his Stocks and Shares ISA allowance. This FTSE…

Read more »