Dividend stocks are companies that pay shareholders a portion of earnings, or dividend, on a regular basis. These payments are funded by profits that a company generates but doesn't need to retain to reinvest in the business. Shareholders can receive dividends as cash, additional shares of stock, or other types of property. As an investment category, dividend stocks also have an impressive track record of helping people build wealth over the long term.

For a company to succeed as a dividend stock, it must have a strong business that consistently generates more profit than it needs to run while also not having a better use of those profits, such as reinvestment in the business, than returning them to shareholders. Moreover, dividend-paying companies also have a clearly defined corporate policy to pay a dividend that's set by their boards of directors.

What kinds of companies are dividend stocks?

While some industries tend to allow for more predictable revenues and cash flows, nearly every industry produces at least a few steady dividend stocks. For instance, the current list of Dividend Aristocrats -- members of the S&P 500 with at least 25 consecutive years of annual dividend growth -- features almost 60 companies from more than a half dozen major sectors.

Hand drawing blue line with dividends written on top.

Image source: Getty Images.

A review of the Dividend Aristocrats further demonstrates that the best dividend stocks come from companies with strong records of generating more earnings than they need to reinvest in the business. The result is a dividend that can be sustained across economic conditions and, in many cases, increased on a regular basis.

Key metrics for dividend investors

A handy metric for measuring a company's dividend sustainability is the dividend payout ratio and its cousin the cash dividend payout ratio. The payout ratio is the portion of a company's earnings -- or cash flows -- needed to pay the dividend. For instance, a company that earns $1 per share and pays $0.50 per share in dividends would have a payout ratio of 50%.

How can you use this metric? As a general rule, the lower the payout ratio, the better. The smaller a portion of a company's earnings it pays out, the more it retains. That should mean the dividend is less at risk of being cut if profits fall.

Companies are often also grouped by the size of the dividend they pay, or the dividend yield. The yield is expressed as a percentage and measures the size of the dividend against the recent share price. For instance, if a stock trades for $10 per share and the dividend over the next year will be $0.20 per share, the dividend yield would be 2%.

How dividends are paid

Most dividend stocks pay investors with cash, but occasionally they may pay with shares of company stock. This stock dividend should not be confused with a dividend reinvestment plan -- sometimes called DRIP investing -- in which investors choose to reinvest dividends in more shares.

In terms of timing, most dividend stocks pay investors quarterly, though a handful pay dividends monthly and a few pay once or twice per year. Several important dates relate to when dividends are paid and who's eligible to receive them, depending on when a stock is bought or sold.

  • Declaration date: The date the next dividend to be paid is announced by the company.
  • Payment date: The date when dividend checks are mailed or funds are transferred to brokerages to distribute to shareholders. Depending on your brokerage, the dividend might not show up in your account on the exact payment date.
  • Record date: This is the date that determines which shareholders receive a declared dividend. Just because you can see the shares in your brokerage account online doesn't make you the shareholder of record. Stock market rules require investors to have purchased shares at least two market days prior to the record date to be the shareholder of record and receive a dividend.
  • Ex-dividend date: This date helps investors understand when they would have needed to own shares of a company to be eligible for a declared dividend. When a stock trades "ex-dividend," it means anyone who buys it on or after that date won't get a dividend that's been declared but not yet paid, as the dividend will go to the prior shareholder, who was the shareholder of record for that dividend.

Why do companies pay dividends?

One important reason a company would choose to issue a dividend stock is to attract investors. Millions of people invest to generate income, and stocks must compete with bonds, real estate, and other fixed-income investments for investor capital. Promising you'll share the profits on a regular basis can make your pool of investors much larger. It's also good policy for companies that generate more earnings than management can put to good use to pay a dividend.

Conversely, there are good reasons for a company to not pay a dividend. For instance, few growth stocks pay dividends, because for many companies in that category, it's a better use of capital to invest in growing the business.

Moreover, companies that aren't consistently profitable might not be able to sustain a regular dividend. For example, cyclical businesses, such as independent oil producers, can see profits swing widely from period to period. If a company has to cut or even stop dividend payments, it's often viewed as breaking a promise to its investors.

So for some businesses, sometimes the best policy is to pay no dividend or to occasionally issue a one-off payment, or special dividend, when appropriate.

Different kinds of dividends

All dividends aren't the same; as a matter of fact, there's a good chance that at least part of what you may think of as a dividend isn't really a dividend. Let's take a closer look at dividends, as well as the other various kinds of payments companies can make to investors, and why the distinctions matter. (Hint: There could be tax implications.)

Qualified dividends

A qualified dividend is the most common type of dividend. It's the type paid by most U.S. companies, and it's more tax friendly. Qualified dividends are taxed at the lower long-term capital gain rate not the marginal tax rate.

To find out if a company pays a qualified or an ordinary dividend, check the investor relations section of its website. For stocks you currently own, box 1b of the IRS Form 1099-DIV will be checked if it's a qualified dividend.

Ordinary (or nonqualified) dividends

Unlike qualified dividends, ordinary dividends are taxed at your marginal tax rate. Here are some common examples of ordinary dividends:

  • Capital gains distributions
  • Dividends on bank deposits
  • Dividends held by a corporation in an employee stock ownership plan (ESOP)
  • Dividends paid by tax-exempt corporations
  • Dividends paid out of ordinary income by REITs (real estate investment trusts)
  • Distributions paid by most limited partnerships and LLCs

Distributions

Many master limited partnerships, publicly traded partnerships, and LLCs are also considered dividend stocks, paying above-average dividend yields. This is because the nature of their corporate structure makes them very cash efficient.

However, most of these kinds of dividend stocks come with a higher tax rate and have a slightly more complex tax form. The Schedule K-1 form divides each investor's share of the business's profits across a variety of categories so that taxes can be assessed appropriately.

Return of capital

With a return of capital, or capital dividend, the dividend you get isn't income: It's the company giving back a portion of the money you invested. Because it's not income, you won't pay taxes on the return of capital.

But the tax man cometh eventually. With a return of capital, you subtract the amount you get from the cost basis you paid. So if you paid $10 per share and a company issues a $0.50-per-share return of capital, your tax basis is now $9.50. That will impact your capital gains -- and the tax on those gains -- if and when you sell that stock.

Special dividends

Unlike regular dividends, which are recurring, a special dividend is a one-off payment from a company that's outside of its regular dividend policy. Often, a special dividend is the result of a company having a particularly profitable few quarters or year, realizing the proceeds from an asset sale, or otherwise finding itself with a significant amount of excess capital that the board decides it should return to shareholders.

Investors should view special dividends as a nice bonus but not as a promise to be repeated.

Preferred dividends

Preferred dividends are issued to owners of preferred stock, which, despite its name, resembles a bond. They feature fixed dividend payouts, and if a company cannot pay all of its promised dividends, those due to preferred shareholders take precedence over those due to common shareholders.

Investing in dividend stocks

Investing in dividend stocks can be very rewarding. Companies that have a track record of paying dividends and then regularly increasing those payouts historically deliver good returns for their investors. This is primarily because only the strongest of companies have the ability to maintain a dividend over the long term, and management must be more disciplined when it allocates capital because there's less of it remaining after paying shareholders.