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

Buying dividend stocks is a strategy that can also be appealing to investors looking for lower-risk investments. Stocks that pay dividends can be some of the least volatile to own. But there are still pitfalls, and dividend stocks can be risky if you don't know what to avoid.

A coin jar with the word dividends on it.

Image source: Getty Images.

How dividend stocks work

Let's look at an example. Say you buy 100 shares of a company for $10 each, and each share pays a $0.30 annual dividend. You would have invested $1,000, and over the course of a year receive $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 can:

  • Reinvest them to buy more shares of the company.
  • Buy stock in a different company.
  • Save the cash.
  • Spend the money (use it to pay a bill or buy a pizza to celebrate).

Regardless of whether the company's stock price goes up or down, you would receive those dividend payments as long as the company continues to disburse them.

The beauty of stocks that pay dividends is that part of your return includes predictable quarterly payments. Not every company offering dividend stocks can maintain a dividend payout in every economic environment -- something that the COVID-19 pandemic has demonstrated -- but a diversified portfolio of dividend stocks can get you reliably paid, rain or shine. 

Combine those dividends with capital appreciation as the companies that you own grow in value, and the total returns can rival and even exceed those of the broader market. 

Examples of dividend stocks

Here are some well-known companies that have a long history of paying dividends, listed along with their dividend yields at recent stock prices and the per-share amount of each dividend:

Company

Industry

Dividend Yield

Quarterly Dividend Amount

3M (NYSE:MMM)

Industrial

3.6%

$1.47

Procter & Gamble (NYSE:PG)

Consumer defensive

2.4%

$0.791

Lowe's (NYSE:LOW)

Consumer cyclical

1.4%

$0.60

Dividend yield and amount as of Jan. 18, 2021. Dividend amount is most recent per-share quarterly dividend paid. 

All three of these companies have increased their stock dividends for more than 50 consecutive years. Because of that, they're in an elite group of companies known as the Dividend Kings, and part of the Dividend Aristocrats -- companies with more than 25 years of consecutive dividend increases. Dividend stocks can come from just about any industry, and the amount of the dividend and percentage yield can vary greatly from one company to the next.

Dividend yield and other key metrics

Before you buy any dividend stocks, it's important to know how to evaluate them. These metrics can help you to understand how much in dividends to expect, how reliable a dividend might be, and most importantly, how to identify red flags.

  • 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 costs $20 per share, then the dividend yield would be 5%. Yield is useful as a valuation metric (by comparing a stock's current yield to historic levels) and to identify red flags. A higher-dividend yield is better, all other things being equal, but a company's ability to maintain the dividend payout -- and, ideally, grow it -- matters even more.
  • Payout ratio: The dividend as a percentage of a company's earnings. If a company earns $1 per share in net income and pays a $0.50-per-share dividend, then the payout ratio is 50%. In general terms, the lower the payout ratio, the more sustainable a dividend should be. 
  • Cash dividend payout ratio: The dividend as a percentage of a company's operating cash flows minus capital expenditures. This metric is relevant because GAAP net income is not a cash measure, and various noncash expenses can cause a company's earnings and its actual cash flows from its operations to vary significantly from one period to the next. This variability can render a company's payout ratio as misleading at times. Investors can use the cash dividend payout ratio along with the simple payout ratio to better understand a dividend's sustainability. 
  • Total return: The increase in stock price (known as capital gains) plus dividends paid. For example, if you pay $10 for a stock that increases in value by $1 and pays a $0.50 dividend, then that $1.50 that you've gained is equivalent to a 15% total return. 
  • EPS: Earnings per share. The EPS metric normalizes a company's earnings to the per-share value. The best dividend stocks are companies that have shown the ability to regularly grow earnings per share over time, and thus raise the dividend. A history of earnings growth is often evidence of durable competitive advantages. 
  • P/E ratio: Price-to-earnings ratio. The P/E ratio is calculated by dividing a company's share price by its earnings per share. The P/E ratio is a 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 buying stocks with the highest dividend yields. While high-yield stocks aren't bad, high yields are typically the result of a stock's price falling due to the risk of the dividend being cut. That's a dividend yield trap

Here are some steps that you can take to avoid falling for a yield trap:

  • Avoid buying stocks based solely on dividend yield. If a company has a significantly higher yield than its peers, that's often a sign of trouble, not opportunity. 
  • Use the payout ratios to gauge a dividend's sustainability. 
  • Use a company's dividend history -- of both payout growth and yield -- as a guide. 
  • Study the balance sheet, including debt, cash, and other assets and liabilities. 
  • Consider the company and industry itself. Is the company's business at risk from competitors, weak demand, or some other disruption? 

Sadly, a yield that looks too good to be true often is. It's better to buy a dividend stock with a lower yield that's rock solid than to chase a high yield that may prove illusory. Moreover, focusing on dividend growth -- a company's history and ability to raise its stock dividend -- often proves more profitable. 

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%. That range is significantly lower than the ordinary income tax rates of 10% to 37% or more (an additional 3.8% tax is levied on certain investment income for the highest earners).

While most dividends qualify for the lower tax rates, some dividends are classified as "ordinary" or non-qualified dividends and taxed at your marginal tax rate. Several kinds of stocks are structured to pay high dividend yields and may 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 extra tax burden doesn't apply if your dividend stocks are held in a tax-advantaged retirement plan such as an Individual Retirement Account (IRA),with the caveat that investing in MLPs can sometimes leave you owing taxes even on 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, also called a DRIP. This powerful tool will take every dividend you earn and reinvest it -- without fees or commissions -- 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 value to work in your favor. 

If you're building a portfolio to generate income today, it's important to remember that paying dividends isn't obligatory for a company in the same way that companies must make interest payments on bonds.And that means that if a company has to cut expenses, the dividend could be at risk. With this in mind, it's important to build your income portfolio with a margin of safety and to diversify across companies with different risk profiles. One way to effectively mitigate risk in your portfolio is by investing in a dividend-focused exchange-traded fund (ETF) or mutual fund. These fund options enable investors to own diversified portfolios of dividend stocks that generate passive income.

You cannot completely eliminate the risk of a dividend cut, but you can lower the risk to ensure that you generate enough income to meet your needs. If stable income is your goal, then focusing on high-quality companies with strong records of dividend growth is far more advisable than buying high-yield stocks that may turn out to be traps.