What is a dividend? How dividends work and how they fit into an investing strategy

One goal of investing is to grow your money over time, and there are many ways to do that. One option is investing in stocks with a history of paying dividends. Below, we’ll review what dividends are and how you can use them to support your financial goals.

What is a dividend?

A dividend is a payment a company may make to shareholders, typically from its earnings. When a company has earnings, it can choose how to use that money – similar to how you decide how to spend your paycheck. Some companies choose to reinvest all their earnings to help their business grow. Other companies may opt to share their earnings by paying dividends to shareholders.

Why would they do that? Dividends can help reward shareholders. When a company is financially stable, it may be able to pay dividends while still investing in growth. Companies in this position might consider paying dividends to encourage loyalty among shareholders and build confidence in the business.

Remember, companies issue stock in the first place to raise money for the business. Paying consistent dividends can be one way to encourage shareholders to stay invested over time.

What are the types of dividends?

Two common types of dividends are cash and stock dividends. With cash dividends – which are the most common – shareholders receive a certain amount of money per share. That cash is typically deposited directly into investors’ brokerage accounts where the shares are held.

With stock dividends, companies distribute additional shares to shareholders according to the number of shares they currently own.

How do dividends work?

Dividends are typically announced in advance and paid on a set date. Companies can choose how often to make those payments, but many do so quarterly. (Some companies, however, may pay dividends monthly, twice a year or annually.)

Let’s say a company’s annual dividend is $2 per share, and you own 100 shares. If the company pays dividends quarterly, then you’d get $50 per quarter – or $200 per year.

There are also special dividends, which are one-time payments companies choose to make when they have extra cash on hand. A company may opt to pay a special dividend following a particularly strong quarter.

Benefits of dividend-paying stocks

There are plenty of benefits to holding dividend-paying stocks in your portfolio, including the following:

Risks and considerations of dividend-paying stocks

Though investing in dividend stocks can be rewarding, dividend-paying stocks are subject to the same risks as other stocks, along with additional considerations.

Here are just some of the items you may want to consider before investing in dividend stocks:

How can you make dividends a part of your investing strategy?

Now that you understand more about how dividends work, let’s talk about how to make dividend-paying stocks a part of your investment portfolio.

Finding the right dividend-paying stocks

While plenty of companies pay dividends, investors should remember that companies can stop paying dividends at any time – either because they choose to or because they can no longer afford to. For this reason, it’s important to select companies whose dividends you believe are both consistent and sustainable if you’re looking to invest in a dividend-paying stock.

Additional factors to consider when choosing dividend stocks include dividend yield and payout ratio. The dividend yield is a ratio of a company’s annual dividends per share divided by its stock price. For example, a company whose stock is trading at $100 per share with a $2 annual dividend has a 2% dividend yield. It’s worth noting that all else equal, dividend yield and stock price have an inverse relationship. When a stock increases in value, its dividend yield will decrease – and vice versa – assuming the company maintains a stable dividend payout through the shifting market conditions.

Payout ratio, which measures the percentage of a company’s earnings that are paid to shareholders as dividends, is calculated by dividing dividends per share by earnings per share. For example, if a company’s annual dividend per share is $2 and earnings per share is $5, you’d divide $2 by $5 to get 0.4, then multiply that by 100 to get 40%.

A higher dividend yield means a company is paying a large dividend relative to its stock price. While that could be considered a good thing, a company sharing too much of its earnings with shareholders may be reinvesting less money in the business. If that leads to less growth over time, a higher dividend yield may become unsustainable. A higher payout ratio could indicate something similar, as distributing an excessive portion of earnings to shareholders could drag on growth and make future dividend payments less viable.

Rather than chasing the highest dividend yields or payout ratios, you may want to focus on companies that have consistently paid dividends. It can also be advantageous to look for companies that have consistently increased their dividends over time.

Building a diversified portfolio

One of the most important things you can do as an investor is ensure your portfolio is diversified. Dividend-paying stocks can be part of a diversified portfolio, as the companies that pay them tend to be in a more mature stage of growth.

This type of investment can help balance out growth stocks in a portfolio, which generally don’t pay dividends (or may pay smaller dividends) because they’re focused on expanding the business. With growth stocks, the return you don’t receive as dividends may show up instead through share price gains.

Reinvesting dividends and DRIPs

Once you collect dividend payments, that money is yours to use as you see fit. One option is to use dividends to boost income. Another strategy is to reinvest.

Many brokerage accounts offer dividend reinvestment plans (DRIPs). With a DRIP, dividend payments that land in your account are automatically reinvested in that same dividend-paying stock. You can also reinvest your dividends manually if you want to branch out into other stocks.

The benefit of reinvesting your dividends – as opposed to cashing them out or letting them sit in your brokerage account as cash – is realizing compound returns. When you use your dividends to buy more stock, those shares can then generate their own dividends, creating a compounding effect that may lead to higher returns over time.

Keep in mind that dividends are generally taxable even when reinvested, though it may depend on the type of account and other circumstances.

The bottom line

Investing in dividend-paying stocks can be a great way to generate income from your portfolio. If you’re looking to put money into dividend-paying stocks, though, make sure to research potential investments carefully. It’s also important to consider them a part of your investing strategy, not your only strategy. With the right approach, you may find that dividend stocks can help your portfolio grow over time, ultimately advancing your long-term financial goals.

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