Dividend investing is a strategy that gives investors two sources of potential profit: the predictable income from regular dividend payments and capital appreciation over time. Buying dividend stocks can be a great approach for investors looking to generate income or those simply looking to build wealth by reinvesting dividend payments.

It can also be appealing for investors looking for lower-risk investments, which can often be found in dividend stocks. But there can be pitfalls along the way, and dividend stocks can be risky if you don't know what to look for. 

Why invest in dividend stocks?

Whether you're looking to generate income from dividends, which are payments a company issues to shareholders, or build long-term wealth for the future, dividend investing can be an excellent way to profit from stocks while also reducing some of the volatility that comes along with stock investing. This is because of the two-pronged nature of the way dividend investing rewards investors: recurring dividend payments and capital appreciation. 

Let's look at an example. Say you buy 100 shares of a company for $10 each, and that company pays a $0.30 annual dividend. You would have invested $1,000, and over the course of a year, would have received $30 in dividend payments. That works out to a 3% yield -- not too shabby. What you choose to do with your dividends is up to you: You could reinvest them in shares of the company, buy stock in a different company, or buy some pizza. Regardless of whether the company's stock price went up or down, you receive those dividend payments so long as the business is able to support them.

Jar, labeled dividends, filled with coins.

Image source: Getty Images.

The beauty of dividend stocks is in the predictable nature of at least part of your returns, particularly if you own a diversified collection of dividend stocks across industries and risk profiles. Then you can factor regular dividends into your portfolio and choose how to best redeploy them.

When you combine dividends with potential long-term capital appreciation as the companies you own grow in value, the total returns from dividend stocks can rival -- and even exceed -- the average returns you can expect from the rest of the stock market. Just make sure to buy great companies and don't get too caught up in chasing big dividends. 

Dividend yield and other key metrics

Before you buy any dividend stock, it's important to know how to evaluate them. The following metrics can help you understand how much in dividends to expect, how safe a dividend might be, and whether you should avoid a particular dividend stock.  

  1. Dividend yield -- The annualized dividend, represented as a percentage of the stock price. For instance, if a company pays $1 in annualized dividends and the stock is $20 per share, the dividend yield would be 5%. Yield is also useful as a valuation metric (for instance, by comparing a stock's current yield to historical levels) and can be helpful to identify red flags. The key thing to know is that, while a higher yield is better, a company's ability to maintain the dividend payout -- and, ideally, grow it -- matters even more.
  2. Payout ratio -- The dividend as a percentage of a company's net income. If a company earns $1 per share in net income, and pays a $0.50-per-share dividend, its payout ratio is 50%. In general terms the lower the payout ratio, the more sustainable a dividend should be. 
  3. Cash payout ratio -- The cash dividend payout ratio can be a handy metric to use alongside the earnings payout ratio, since earnings can vary significantly from cash flows, particularly from one quarter to the next. 
  4. Total return -- The overall performance of a stock, the combination of dividends and gains or losses from share price change. For example, if a stock rises by 6% this year and pays a 3% dividend yield, its total return is 9%.
  5. EPS -- Earnings per share. In general, a company must earn more than its dividend in order to sustain it, and this metric normalizes its results to the per-share value. The best dividend stocks are companies that have shown the ability to regularly grow earnings per share over time. Companies that consistently grow earnings per share often have strong competitive advantages. The result is a company that can keep paying its dividend and potentially increase it.
  6. P/E ratio -- The price-to-earnings ratio divides a company's share price into earnings per share. P/E ratio is a valuation metric that can be used along with dividend yield to determine if a dividend stock is fairly valued. 

High yield isn't everything

Inexperienced dividend investors often make the mistake of looking for only the highest yields. While high-yield stocks aren't bad, in many cases, high yields can be the result of stock price that's fallen on expectations that the dividend will get cut. That's a dividend yield trap. 

There are a few steps you can take to avoid falling for a yield trap:

  • Avoid buying stocks based solely on the highest yield. A company that boasts a significantly higher yield than its peers may signal trouble. 
  • Use the payout and cash payout ratios to measure a dividend's sustainability. 
  • Use a company's dividend history as a guide. 
  • Study the balance sheet, including debt, cash, and other assets and liabilities. 
  • Consider the business and industry itself. Is the company at risk from competitors or weak demand?

A yield that looks too good to be true, sadly, often is. It's better to buy a dividend stock with a lower yield that's rock solid than chasing high yield that may prove illusory. Moreover, focusing on dividend growth -- a company's history and ability to raise the dividend -- can prove more rewarding than chasing yield. 

How are dividends taxed?

Most dividend stocks pay "qualified" dividends, which, depending on your tax bracket, are taxed at a rate of 0% to 20%, significantly lower than the ordinary income tax rates of 10% to 39.6% (plus a 3.8% tax on certain investment income for the highest earners).

While most dividends qualify for the lower rates, some dividends are classified as "ordinary" dividends and are taxed at your marginal tax rate. There are several kinds of stocks that often pay above-average dividend yields that may also come with higher tax obligations because of their corporate structures. The two most common are real estate investment trusts, or REITs, and master limited partnerships, or MLPs. 

Of course, this doesn't apply if your dividend stocks are held in a tax-advantaged retirement account such as an IRA, with the caveat that some MLPs can leave you owing taxes even in your IRA. 

Dividend investment strategies

If you're a long-term investor looking to grow your nest egg, one of the best things to do is use a dividend reinvesting plan, usually called a Drip. This powerful tool will take every dividend you earn, and reinvest it -- fee and commission-free -- back into shares of that company. This simple set-it-and-forget-it tool is one of the easiest ways to put the power of time and compounding work in your favor. 

If you're building a portfolio to generate income today and won't be able to reinvest every dividend, the best strategy is to identify companies that pay an acceptable yield based on your income needs, with a solid margin of safety. Use the payout ratios and their historical results as a guide, as well as other valuation measures like P/E ratio to build a diverse portfolio of dividend stocks you will be able to depend on.