Key Takeaways
- Among the main European stock markets, dividends can often increase returns by more than 2 percentage points annually over just the price returns on stocks.
- In the UK, dividends increased returns by 55 percentage points over the last decade.
- Compared to US peers, European companies tend to focus more heavily on dividend payouts than on reinvesting profits and fueling stronger growth.
Dividend-paying stocks offer an attractive way of generating income and providing ballast to a portfolio during market turbulence. But when it comes to investing in European stocks markets, dividends play a critical role in boosting a portfolio’s overall returns.
Assuming reinvested dividends, the UK stock benchmark returned more than double what the simple price appreciation of its member stocks achieved. The often-cited FTSE 100 index can therefore understate what investors stand to gain by remaining invested in the long term.
Indexes like the FTSE 100 or the US S&P 500 are well-known, but they are price return indexes, designated by the letters PR. They only reflect the price performance of the index components stocks without including the dividends paid by those companies. When a company pays a dividend, that dividend is deducted from the price of the security.
To measure total return, the dividends paid by the components of that index must be added to the price performance.
While not all companies pay dividends, and some pay more than others, the difference between price return and total return is very significant over time. For example, over the last five years, the difference between the Morningstar UK Price Index (Morningstar UK PR) and the Morningstar UK Index incorporating the reinvestment of net dividends (Morningstar UK NR) is 4 percentage points a year, as the table below shows.
An NR index is a “Net Return” index, meaning that dividends are included in the index performance calculation after the deduction of withholding taxes.
This means that the returns on stock markets, which are represented by well-known country-level benchmark indexes, are much lower than the actual returns obtained by the components of those indexes, especially over long-term periods. For example, the cumulative return over the last 10 years for the Morningstar UK PR is 45.5%, compared to a return of 111.5% for the Morningstar UK NR, a total return index.
This difference in returns can be explained by the compounding effect of dividends being paid year after year.
Dan Lefkovitz, strategist for Morningstar Indexes, says “dividends represent an important component of the returns offered by the stock market. In a given calendar year, it can be easy to overlook dividends’ contribution. But over the long-term, the compounding effect of reinvested dividends is meaningful.”
Why the Dividend Gap is Larger in Europe
The gulf between price performance and total return is greater in Europe than in the US due to European companies’ generally higher dividend yields.
According to Morningstar’s Lefkovitz, one reason for the US’s lower dividend yield lies in differing corporate approaches to returning capital to investors. Historically, US firms have prioritized share buybacks over dividends. European companies, by contrast, allocate more of their profits to dividends, driven by a stronger focus on steady income.
Another reason is the different compositions of the US and European equity markets. In the US, it’s dominated by fast-growing industries such as technology, where firms tend to focus on plowing profits back into growth rather than distributing them as dividends, which keeps overall yields low. By comparison, Europe’s market features a greater presence of established, dividend-friendly sectors like banking, utilities, and consumer goods, which help drive up yields.
In the United States, the sector with the greatest weight in the Morningstar US Market Index has a relatively low yield: The technology sector, which accounts for 33% of the index, has a dividend yield of just 0.5%.
In Europe, the situation is the opposite. The sector with the greatest weight in the Morningstar Europe Index, the financial sector, with a weight of 23%, has a dividend yield of 3.4%.
