Dividend Basics

Historical records show that more than 50% of the long-term return from stock investing has come from dividends. As you contemplate growth rates, future cash flows, pending patents, FDA approval, or international expansion at the companies you follow, remember that there are only two ways to get paid from the stock market: dividends and buying low, selling high.

Not only do dividends give you cash in hand or more shares in your account, they're a powerful indicator of the company's cash-raising abilities and management confidence. Indeed, most of the businesses I look for in Motley Fool Inside Value sport healthy dividends.

A back-to-school refresher
In honor of the Fool's recent back-to-school theme, now is a particularly good time for a refresher course on dividends. A dividend is a taxable payment declared by a company's board of directors. Dividends are typically paid quarterly, in cash, although they can be stock or other property (think Anheuser-Busch paying out with a six-pack or two). If your broker holds your shares, they will be paid directly to the broker, who will then credit your account.

A dividend yield is simply the annual dividend divided by the share price expressed as a percentage. For example, consider the recent yields for the following companies:

Eligibility requirements
A dividend is not a right. In fact, fewer companies pay out dividends today than 50 years ago. It is up to the company's board of directors to both declare the dividend and the amount to be paid to shareholders. In practice, companies are loath to reduce dividends, because shareholders take a very dim view of such action. Companies that have a long history of raising dividends are usually a good investment -- they have demonstrated an ability to increase cash flow to enable their dividend payments. After all, a company can't easily fake its cash flow! It must generate enough cash to consistently pay dividends.

There are four important dates associated with dividends

• The Declaration Date: The day that the board of directors declares the dividend. This is usually done through a press release.
• The Ex-dividend Date: The day on which the stock will trade without the dividend. If you are selling shares and want to receive the dividend, you should sell on or after this date. On the other hand, if you are buying shares, you must buy before this date to receive the dividend.
• Date of Record: To receive the dividend, you must be recorded as the owner of the shares in the company's records. When shares change ownership, it takes three business days for the transaction to be recorded. As such, the date of record is two business days after the ex-dividend date.
• Payable Date: The day the payment is mailed out or transferred to your broker on your behalf. In practice, this can vary anywhere from a week to six weeks after the date of record.

Drip, drip, drip
A company's dividend reinvestment plan (DRIP) is usually associated with its Direct Share Purchase Plan. The DRIP plan allows individuals to reinvest their dividends by purchasing additional shares directly from the company. This can be advantageous because there is no brokerage fee, and the company will allow you to buy fractions of a share. Not all companies have a DRIP program, and some do have administration charges, particularly if you want to sell. You should check the company's website and/or contact investor relations for program details. Particularly check to see whether they have an associated direct share purchase plan (DSPP), since this will allow you to purchase shares directly without incurring brokerage fees.

Synthetic DRIPs
Most brokerages will allow you to reinvest dividends, but these are not true DRIP programs. First, some will only reinvest in whole shares, meaning you must have a big enough quarterly dividend payment to be able to afford to buy at least one share.

Inside Value selection First American (NYSE:FAF), for instance, pays out an annual dividend of $0.72. The dividend is paid in quarterly installments of $0.18. To be able to purchase one share each quarter, I would have to buy at least 225 shares at the recent price of $40.50. However, should the share price rise above $40.50, I would not be able to reinvest, and the cash would simply be paid into my account.

The Foolish bottom line
Understanding how and why dividends are paid out by companies is an essential part of being a great investor. Not only do they give you extra purchasing power, they can also reveal a great deal about a company's financial health and its attitude toward shareholders.

This article was adapted from a Motley Fool Inside Value "Valuable Knowledge" column.

Philip Durell is the advisor/analyst of Inside Value, the Fool's value-investing newsletter service. Since inception, Philip's recommendations have outpaced the S&P 500 by more than four percentage points. You can view all his recommendations with a free 30-day trial. Follow this link for more information.

Philip owns shares of First American. Anheuser-Busch and First American are Inside Value recommendations. Merck was a former Income Investor pick. The Motley Fool has adisclosure policy.