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Everything You Need to Know About Dividends (The Short Version)

By Dan Caplinger – Apr 9, 2018 at 11:41AM

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Different investors have varying goals for their portfolio. For some, high-growth stocks that have the potential for explosive share-price gains are critical to help them earn as high a return as possible. Yet what many investors find -- especially later in life -- is that they also need to draw current income from their investments. Dividend stocks are a great way for this second group of investors to meet their needs, because they offer both cash payments right now as well as the chance to see their share prices go up in the future. Here's everything you need to know about dividends.

What is a dividend?

A dividend is a payment that a company makes to its shareholders. The company will declare an amount per share that it will pay to investors who own its shares as of a specific point in time. If you own shares of the stock on that date, then you'll be entitled to receive the dividend. The more shares you own, the larger your dividend will be, as dividend payments are made on a per-share basis.

Most companies in the U.S. that pay dividends do so four times a year, with payments typically in equal amounts. However, you'll find other stocks that pay dividends as frequently as monthly or as rarely as once a year, and some companies have variable dividend policies that can lead to very different dividend amounts from payment to payment.

Blue background with symbols for different market sectors, and word Dividends prominently featured.

Image source: Getty Images.

How big a dividend is normal?

There's no set standard for how big a dividend companies should pay. In some industries, especially some newer cutting-edge technology areas that are full of small companies that need all their available capital to fund growth efforts, it's rare to see any dividend at all. For more mature businesses like telecommunications and consumer goods companies that generate a lot of cash, higher dividends are much more frequent.

Many investors look at a stock's dividend yield to compare the size of its payouts. To figure the yield, take the annual amount the stock pays in dividends and divide it by its share price. Currently, the overall market's average dividend yield is about 2%. But investors who like dividends often turn to specific industries that have traditionally had higher yields. For instance, telecom stocks have yields that have been in the 4% to 5% range recently. Special niche investments like business development companies, royalty trusts, and real estate investment trusts that specialize in mortgage securities can have even higher dividend yields that in some cases will exceed 10%.

Can I rely on a stock's dividend?

There's no obligation for any company to pay a dividend to its shareholders. Therefore, investors need to be prepared for the possibility that a company that has made dividend payments in the past will stop doing so. That happens most often when companies face financial challenges that require them to take the cash they've paid in dividends and use it for other business purposes, such as paying down debt or reinvesting in their core operations.

One metric that dividend investors use to measure dividend safety is the payout ratio. This figure typically compares the amount a company pays in dividends with its earnings. Payout ratios over 100% indicate that dividend payments are higher than earnings, which for most companies is a warning sign that a dividend cut might be necessary if earnings don't grow in the near future. Healthy companies typically have payout ratios below 60%, leaving plenty of unused earnings for use in the business or to make strategic acquisitions. For some industries, accounting standards make it smarter to compare dividends to free cash flow rather than earnings in order to judge whether a dividend is sustainable.

Why dividend stocks deserve a closer look

Dividend stocks aren't just useful for those who need current income from their portfolios. When you look back over the past 45 years, dividend stocks have dramatically outperformed their non-dividend-paying counterparts, and companies that have consistently increased their dividends over time have done even better .

Moreover , those who reinvest their dividends can dramatically increase their total returns. Over the past half century, about a third of total returns from the stock market have come from dividends. That might not sound like much, but over a long span of time, those who use their dividends to buy more shares of stock in a company end up with exponentially larger amounts of wealth than those who don't.

If you haven't looked at dividend stocks lately, now's a good time to consider whether they deserve a spot in your portfolio. By combining income payments now with potential gains later, dividend stocks offer many investors what they believe is the best of both worlds.

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