last updated February 19, 2015

A successful companyone which earns real money every year has three options. It can reinvest those earnings into the company to make new products, find more customers, build new stores or factories, or make the business more efficient. It can buy back its stock so that each remaining share owns more of the company (and more of next year’s profits). It can return some of that money to shareholders in the form of dividends. As part of learning how to invest in stocks. you need to understand how dividends work.

Paying Dividends

Think of dividends like interest on a loan. Suppose you loan your best friend $1000 for a year at 5% interest. You expect to get back your $1000 plus that 5%, or another $50. A dividend is sort of like that, except the $1000 stays in the company because you still own part of it. It’s your portion of the profit the company made.

Not all companies pay dividends. Some companies don’t make any profits, so they can’t pay out anything (without taking out a loan). Other companies pour all of their money back into the company to grow faster. That’s a reasonable choice. What works for one business doesn’t work for others.

Why Do People Invest in Dividend Paying Stocks?

Some people like investing in companies that pay dividends every year. (A reliable company like Coca-Cola pays out handsomely every quarter.) Even if the price per share of their stock doesn’t go up much every year, they still make money from these payments. Better yet, they don’t have to sell their shares to get that money. The check comes every quarter.

This money gets paid to all shareholders, regardless of the number of shares they own. A retired grandmother in Canada who owns one share of Coca-Cola gets her dividend the same way a wealthy hedge fund manager who has a fifty million dollar portfolio and lives on the beach in Costa Rica does.

High Dividends

Of those stocks which do pay dividends, it’s common to see payments of about 2% of the value of the stock every year. In other words, if the stock costs about $100, the dividend you get per share will be about $2 every year. That’s a 2% return on your investment, before taxes and fees. (Once you take into account federal and state income taxes and inflation, that doesn’t sound like much, does it?)

Some stocks pay no dividends, of course, but other stocks pay higher dividend rates5%, 10%, or more.

Why are these dividends high? Remember that we’re talking about the dividend yield. A company with a share price of $10 which pays a dividend of $1 per share every year has a dividend yield of 10%, while a company with a share price of $100 which pays out $1 per share every year has a dividend yield of 1%.

As always, the price you pay for a stock governs how much money you make on that stock. (Though keep in mind that you will rarely see penny stocks pay dividends!)

How Can You Tell if a Stock Pays Dividends?

The easiest way to tell if a stock pays dividends is to look at any stock research site, like Google Finance or Yahoo! Finance. You should see a dollar amount for latest dividend announced, annual amount paid, and current yield. Check these dates; a stock may pay out one quarter and not the next.

Should You Invest in the Highest Dividend Paying Stocks?

Not necessarily! A high dividend paying stock is a stock that’s paying more than the average dividend rate (if you look at all stocks that pay dividends they pay, on average, 2.5% annually). Perhaps you’ve found a company which pays much more. Companies that pay high dividends may do so because they’re good companies. or because they want to attract investors to drive up the share price. It may be a sign that the share price has gone down, dramatically down, recently. (Sometimes this means the stock is on sale! Great! Other times it means that the company is in trouble.) You can’t know this just by looking at the share price and the high dividend amount; you have to understand the company’s business and its current financials.

Keep in mind that a company must choose to pay a dividend. Just because it paid one last quarter doesn’t necessarily mean that it will pay one this quarter. As well, the amount paid is up to the company. Even if it paid $1 per share last year, it may pay $0.02 per share this year.

The Best Dividend Paying Stocks

Investing in dividend paying stocks can be a good investing strategy, especially if you want revenue coming in reliably. Yet remember that word, reliable .

Reliability is more important than a high payout. Dividends aren’t guaranteed. A company that paid a huge amount of money last year but may not pay it again this year isn’t necessarily a bargain or a find. You still have to do your research. You still have to buy great companies, not just stocks that pay the highest dividends per share.

Are high dividend stocks a good investment? Not necessarily! Pay attention to how they’re paid. Do they pay them every year? Every quarter? Does the company raise its payment amount on a regular schedule? The best dividend paying stocks (Coca-Cola is a great example; Coca-Cola stock is a good investment, though it’s not always available at a great price!) do this. In fact, if you bought Coca-Cola at a great price a couple of decades ago, you could make more from dividends every year per share than you paid for the stock.

Can the company even afford to pay out this year? How about next year? A company that pays a huge dividendespecially one disproportionate to its earnings and free cash flow is a warning sign. How does the company plan to continue its payment strategy? Is this a temporary trick of accounting to draw in uncautious investors to inflate the stock price to artificial levels? Be wary. Rely on reliability.

Good Dividend Stocks to Buy for Value Investors

If you find yourself asking What are the best stocks to invest in? or What are the reasons to invest in a company?, dividends may be a sign of a good stock belonging to a good company. Not all great stocks pay dividends, though. Some never do. Some pay sporadically. It depends.

At Trendshare, we track dividend yield, but we don’t currently track dividend history. Dividends are great, and many great companies have good dividend stocks to buy. Yet value investing looks for underpriced stocks. Sometimes they pay dividends. Sometimes they don’t. If you find a great company that gives you a check every quarterand if the price is rightthen you’ve found a true gem.

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