What Are Dividends and Dividend Stocks?

Companies have three basic ways to use extra capital: They can invest that money back into the business, buy back a portion of the company's shares, or pay a dividend. When stock investors are seeking returns, dividends are icing on the capital-appreciation cake.

What's a dividend? A dividend is a periodic cash payment made to shareholders on a per-share basis, so the more shares of the dividend-paying company you own, the more dividends (aka big cash money) you receive.

Not every company pays a dividend. Younger, high-growth companies often find their capital is best spent elsewhere, investing directly into the business rather than handing that cash over to shareholders. Larger, more mature companies tend to go the dividend-paying route. So in many ways, a dividend is a sign of stability. There are a variety of dividend-paying companies, from real-estate investment trusts, which are required by law to pay dividends, to tried-and-true conglomerates that have been paying dividends for years. Regardless, a dividend can mean extra money in your pocket.

Investing in Dividend Stocks

It's not enough just to know that a company pays a dividend. You also want to know how you can invest in dividend-paying stocks, how much they pay, and whether those payments are sustainable. Time for some jargon.

A "dividend yield" equals the annual dividend per share divided by the price per share and is listed as a percentage. For income investors, this number can be pretty important. A high-yielding stock may be more attractive than, say, a low-yielding CD or money-market account. At the very least, some investors hope the yield beats inflation. Keep in mind that a higher yield doesn't mean a better dividend stock. It simply indicates how much dividend cash you're getting from your investment.

Now for another term: "payout ratio." This equals the annual dividend per share divided by the annual earnings per share, and it indicates how much of a company's earnings are devoted to paying a dividend. When a company's payout ratio exceeds 100% it may be a warning sign that the dividend isn't sustainable and a dividend cut may be on the horizon. Dividends are far from guaranteed, but a cut in a dividend tends to send investors running for the exits.

Keep in mind that this ratio shouldn't be applied to entities required by law to pay out dividends (we're looking at you, REITs and MLPs!), and for some industries, free cash flow or another indicator may be more useful. But for standard dividend-paying stocks, the payout ratio can help. Remember to look at a company's dividend-paying track record as well. A stock with a high payout ratio, volatile earnings, and a limited dividend-paying track record could face trouble ahead.

"DRIPs," or dividend reinvestment plans, allow investors to reinvest their cash dividends in shares of the company. Instead of receiving a quarterly or annual dividend check, you get that amount reinvested (commission-free) in company stock. DRIPs offer the "set it and forget approach," where an investor can buy stock over time using dollar-cost averaging. Both companies and brokers offer DRIPs.