"Do you know the only thing that gives me pleasure? It's to see my dividends coming in."
-- John D. Rockefeller, co-founder of Standard Oil and the richest man in American history

At some point in your life, someone may have said to you, "It'll pay dividends down the road" after you've put an immense amount of work into something. That was their way of saying that the work you did would pay off big-time in the future. Well, that same idea can apply to the money you save. Invest it in the right ways, and it has the potential to pay dividends for decades. 

I'm talking, of course, about dividend stocks. For as long as the stock market has existed, many companies have made a habit of paying dividends, and some of the greatest fortunes in America were made through ownership of dividend stocks. 

So let's explore the idea of dividends, why companies pay them, why investing in them can be so lucrative, and what you should look for when evaluating an investment in dividend stocks.

Image Source: Pictures of money via Flickr.

What is a dividend?
A dividend is a regular payment made to the owner of a stock or bond. The most common dividend policy for United States-based companies is a quarterly payment set by management. It's also common for companies to pay out a percentage of annual net income or any excess free cash flow after capital expenditures are paid for.

The reason quarterly dividend payments are so prevalent in the U.S. is that shareholders like a steady and reliable payout, especially if they use those dividends as an income stream.

For the most part, dividends are considered a long-term capital gain and are taxed as such. However, there are other investments that pay dividends or distributions differently because of their corporate structure. Here are a couple examples:

  • Master Limited Partnership (MLP): An MLP is a corporate structure that is known as a "pass-through entity." Instead of paying corporate income taxes, the company passes the tax obligation to its unitholders (that's MLP jargon for "shareholders"). Therefore, you as the individual are responsible for the taxes on your share of the company's income. The MLP structure is limited to companies that generate more than 90% of their income from qualified sources such as natural resources, real estate, and capital gains from other investments.
  • Real Estate Investment Trust  (REIT): A REIT is a trust that holds a group of properties and/or mortgages. REITs are also free from corporate income taxes, but they must pay out 90% of their income in the form of a dividend. However, REIT dividends are paid from cash flow, and investors get the benefit of deducting their portion of depreciation, a non-taxable return on capital. So the amount on which investors are taxed is lower than what they receive from the REIT.

There are a bunch of other special corporate structures that pay dividends in different ways, but it would take a whole book to go through them. Further, there are a slew of rules related to dividends if the dividends are held in tax-advantaged accounts such as IRAs. So be sure to do your homework on the type of dividend you are receiving and how it is treated tax-wise.

Here are some common terms associated with dividends you should know:

  • Cost basis: The price at which a stock or bond is bought. This is a number that can change when shares of the stock are bought or sold over time and can impact the return from dividends.
  • Dividend yield: The total annual cash a company pays in common dividends divided by its stock price. For example, if a company pays $1.50 per year in dividends, and its shares are valued at $100, then its dividend yield is 1.5%. Yield is frequently used to evaluate dividend-paying stocks, as it indicates how much dividend income you'll get for the money you invest.
  • Ex-dividend date and record date: These two dates relate to whether a shareholder is eligible to receive a dividend for owning a stock. If someone is not an owner of shares prior to the record date, he or she is not eligible for a dividend the day it is paid.
  • Dividend reinvestment plan (DRIP): This is a program in which the dividends received are paid in the form of more shares in the company. Rather than a check, the shareholder gets a larger stake in the issuing company.
  • Payout ratio: The percentage of the company's net income that is paid out in dividends. This is a common metric for evaluating a company's capital allocation and the sustainability of its dividend. We'll get into this in a bit.
  • Qualified dividends: Dividends that can be taxed as a long-term capital gain and not as income. Most dividends from common stocks are considered qualified dividends if the stocks are held for a long time. 
  • Return of capital, a.k.a. capital dividend: A distribution paid to a shareholder that isn't considered a taxable item when it is paid. Instead, taxes are paid when the shares are sold, because the return of capital lowers the cost basis.
  • Total return: The return on a stock holding including both share-price appreciation and dividends paid. If a company's shares increase 5% and pay a 3% dividend yield, then the total return is 8%.
  • Total return index/total return price: A measure of long-term returns on dividend stocks. It calculates the performance of a stock assuming all dividends are reinvested right back in the stock.
  • Yield on cost: The total cash dividend paid divided by your cost basis. As a company's dividend payments increase, the yield on cost can be much greater than the advertised dividend yield. 

John D. Rockefeller, a man whose wealth once accounted for 1.5% of the U.S.' GDP, made that fortune mostly through the dividends from Standard Oil. Image Source: Wikimedia Commons.

Why pay a dividend in the first place?
When a company pays a dividend, it gives away the cash it has generated that can no longer be reinvested in the business. To some, this can be seen as an inefficient use of the company's capital. Truth be told, some companies can only reinvest so much back into the business before it becomes an inefficient use of capital. So when you have a company that generates lots of cash in excess of capital expenditures, giving that money back to shareholders via dividends can be an effective means of increasing shareholders' return.

Whether management decides it's best to issue a dividend largely depends on what stage a business is in. A company in a fast-growing field that needs to constantly innovate will likely need to reinvest that money back in the business, whereas a larger, more mature company that has slower growth rates and a solid financial footing is much more likely to pay a dividend to its shareholders. Besides, the only less effective use of that cash would be to leave it sitting on the balance sheet for years, losing value to inflation.

A dividend stock can be a lucrative investment
Many investment strategies have shown to be effective ways to generate wealth over time, as evidenced by the famous people who have used them. I won't go so far as to say that investing in dividend stocks is the one true method of beating the market or getting rich, but when it's used the right way, it can be highly effective. For investors, companies that pay dividends have two distinct advantages over their non-dividend-paying counterparts:

1. An income stream that doesn't eat away at the principal investment: Hopefully, you've been saving for years and are approaching a time when you don't need to work as much and can use your investments to supplement your income. If you're invested in dividend stocks, then the cash payments given out quarterly can be taken out of your account to cover some of your expenses. Meanwhile, non-dividend-paying investments may require you to sell shares in order to raise cash, eating away at your nest egg. Some investing theories state that there's little difference between selling shares and allocating dividends to cash, but that's up to you to decide.

2. Reinvested dividends + time = powerful wealth-building tool: Perhaps you're still far from the day when you'll be living off your investments, so you don't really need the cash from dividends today. That doesn't mean you should shy away from dividend stocks. Instead of taking that cash and running every quarter, you can simply funnel it back into that same stock through dividend reinvestment plans. When you reinvest dividends, not only does your investment grow through price appreciation, but each dividend turns into more shares. Compound that over 20 or 30 years, and you can turn a small investment into a massive holding.

The chart below shows the true power of reinvested dividends. The blue line represents the price increase of ExxonMobil (NYSE:XOM) over the past 40 years. The second one is the total return -- share price appreciation plus dividends reinvested -- for ExxonMobil over that same time period.

 

XOM data by YCharts.

Let's get some perspective on those numbers. If someone had invested $10,000 in Exxon 40 years ago, that same position would be worth $328,000 and would have thrown off about $100,000 in cash in the process. Not too shabby. But if you had taken those cash payments and reinvested them right back into shares of the company each quarter, that exact same $10,000 investment would be worth $878,000 today, turning a rather impressive 9.28% compounded annual growth rate into an astounding 11.28% annual return!

ExxonMobil isn't the only company that has put up these kinds of numbers, either. Just look at the price returns versus total returns for other industry stalwarts like Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), and Johnson & Johnson (NYSE:JNJ).

PG data by YCharts.

It may take a long time for reinvested dividends to really make a difference in one's portfolio, but the the longer you hold that dividend position, the greater the benefit becomes.

What to look for in dividend stocks
There's a reason that these companies have generated such amazing returns through reinvested dividends: All of them have reputations for paying consistent dividends that generally increase on an annual basis. Quarter in, quarter out, they provide their shareholders with some form of cash payment. Of all the companies listed, the only one to cut its cash payout to shareholders was ExxonMobil, and that happened back in 1982.

Companies that have developed these long track records of uninterrupted annual dividend increases have a nickname: Dividend Aristocrats. These companies have paid a dividend every year for at least 25 consecutive years, making them the cream of the crop. The following are the five companies with the longest records of uninterrupted dividend increases on the market:

Company Years of Consecutive Dividend Payments Current Dividend Yield
Diebold 61 3.5%
American States Water

60

2.1%
Dover Corp. 59 2.6%
Northwest Natural Gas 59 3.9%
Procter & Gamble 58 3.5%

Source: dividend.com.

So as you look to build your own portfolio with dividend stocks, a company with a reputation for paying dividends over decades-long periods is certainly a plus. Benjamin Graham, the godfather of value investing and one of the early influences on Warren Buffett, said that a quality dividend stock should have at least a 20-year history of paying dividends before investors even considering buying shares (he was a pretty conservative guy). Just because a company has paid dividends for years prior, though, does not mean it can continue to do so. After all, Eastman Kodak was a Dividend Aristocrat for years before going bankrupt in 2012. 

When investing in any company, whether it pays a dividend or not, you need to have a basic understanding of the business's fundamentals and whether they have the possibility to hold up for the long term. While we can't predict the future, there are some aspects of our lives that likely won't change much. Companies that have a strong established business in providing some of our most basic needs -- food, hygiene, etc. -- are likely to keep doing well for years to come. In that same vein, companies that have strong competitive advantages over their peers are even more likely to succeed in these basic-necessity businesses.

Dividend sustainability, by the numbers
After you've established that a company's competitive position in the market is solid, the next question you have to ask is whether its dividend payment is sustainable. The most common way to evaluate this is to calculate the payout ratio. The dividend payout ratio compares the total dividend paid to shareholders to the company's earnings.

If you really want to get technical about it, earnings are a non-cash payment. It's the theoretical value added to the company after conceptual costs like depreciated equipment are accounted for. So, to get down to the nitty-gritty of dividend sustainability, you need to look at the cash payout ratio. This is the total amount of the dividend paid out divided by its free cash flow (i.e., cash generated from operations minus cash from investing).

Here's how these two numbers can differ using some of the companies above as examples:

Company Earnings Payout Ratio Cash Payout Ratio
Coca-Cola 91% 220% 
Procter & Gamble 103% 60%
Johnson & Johnson 49% 83%
ExxonMobil 50% 163%

Source: S&P Capital IQ.

So in these examples, Coca-Cola and ExxonMobil have made heavy cash investments in the business over the past 12 months -- ExxonMobil is in a capital-intensive industry, and Coca-Cola has spent $6 billion in the past 12 months on acquisitions and other equity investments, so these companies' cash payouts look weaker compared to their earnings payout ratios, which don't reflect those cash investments. Conversely, Procter & Gamble had a large non-cash expense that affected its earnings payout ratio but had no impact on its cash flow, which was more than adequate to cover its dividend. Knowing how to navigate these two metrics can help give a much clearer picture about what's going on at the company and whether it will be able to maintain or raise its dividend in the future. If a company fails both the earnings and the cash payout ratio test, then chances are something is really fishy.

Make your money work for you
Investing in dividends can be an extremely effective method for growing wealth over time. One look at the riches amassed by famous businessmen and investors like John D. Rockefeller, or the total returns of stocks over long time periods, is evidence enough. Just like every other investing strategy, though, dividend investing needs two things to succeed: a willingness to stay firm through thick and thin, and time. With these two assets at your disposal, an investor can take something as boring as selling sugar water, oil, and bandages and turn it into a bountiful source of wealth.

Tyler Crowe owns shares of ExxonMobil. You can follow him at Fool.com or on Twitter @TylerCroweFool.

The Motley Fool owns shares of ExxonMobil and has the following options: long January 2016 $37 calls on Coca-Cola, short January 2016 $43 calls on Coca-Cola, and short January 2016 $37 puts on Coca-Cola. The Motley Fool recommends Coca-Cola, Johnson & Johnson, and Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.