Whether a stock pays dividends may play a big role in your investment strategy. A dividend provides a source of income. It offsets losses. When reinvested, it compounds growth. But this isnt an argument that dividend paying stocks are better. Its an introduction to dividends, giving you an idea of what to expect and what to watch out for when owning dividend stocks.

There are three things a company can do with its profits. Reinvest it to further grow the company. Do a share buyback. which should increase the stock price over time. Or return the money to shareholders in the form of a dividend. Most companies combine the three to offer the best return for shareholders.

What Is A Dividend?

A dividend is a piece of a companys earnings paid out to shareholders. When a company pays a dividend its usually done quarterly. There are a few companies that only pay annually or bi-annually, but it is not the norm.

The Dividend Yield

If you take the annual dividend and divide it by the stock price, you get the dividend yield. The yield tells you the percentage of the stock price the company will pay you back in dividends. The yield fluctuates as the stock price rises and falls. A higher stock price gives a lower yield. A lower stock price brings a higher yield.

High yields can be a cause for concern. Either the stock price has fallen significantly or the company is growing at an extremely low rate. If the company cant keep paying a high dividend yield, you probably dont want to own its stock. Looking into the payout ratio, discussed below, will give you an idea if that high yield is at risk.

If we look at McDonalds Corp. dividend stats it currently pays an annual dividend of $3.08 per share ($0.77 per share each quarter) which is a 3% yield. If you own 100 shares of McDonalds, every three months the company will pay you $77 ($0.77 x 100 = $77) which you can spend or reinvest.

The Dividend Date

McDonalds Corp. (MCD) Dividend Stats

The dividend date is the day the check is put in the mail. Or credited to your brokerage account. Make sure to keep track of the dividend dates, so you know if you get paid or not. For our example, McDonalds paid its last dividend on March 14, 2013.

The Ex-Dividend Date

The ex-dividend date is the most important date to remember. It determines which shareholders get paid a dividend and which dont. You must own the stock before the ex-dividend date to receive the next dividend payment.

If the ex-dividend date is today and you buy the stock today, you wont be paid the next dividend. However if the ex-dividend date is today, but you bought the stock yesterday or earlier, you will be paid the next dividend payment.

When you own dividend paying stocks, you should be tracking the ex-dividend dates. The last thing you dont want to accidentally sell a stock before the ex-dividend date and miss out on a payment. Additionally, if you want to buy more shares, do so before the ex-dividend date.

Again, using the McDonalds Corp. example, you had to own shares before the ex-dividend date of Feb. 27, 2013 to be paid that quarterly dividend on March 14, 2013.

The Payout Ratio

Investing is more than just owning a stock because it pays a dividend. It only takes one bad year for a company to cut or cancel future dividends payments. A little extra research will tell you if those dividends are at risk. This is where you use the payout ratio the dividends per share divided by the earnings per share.

The percentage of earnings paid out in dividends, or payout ratio, will tell you two very important things:

• how much earnings are being reinvested in the company for continued growth
• if those earnings will be able to support the continued payment of a dividend

A low payout ratio tells you the company is reinvesting more of the earnings back into the company. This is generally a sign of growth. Or, at the very least, management is putting more earnings back into the company. Should the company have a bad year, the low payout ratio should provide enough wiggle room to still pay the dividend. Its much easier to pay a dividend when its a small percent of the earnings.

On the other hand, high payout ratios can be a warning sign. It shows that more earnings are being paid out to shareholders. This might sound good to shareholders, but it can limit the companys growth. When a company stops growing, the stock price stops growing. Thats never a good sign.

With a high payout ratio, one down year for a company may be enough to cut or cancel the dividend altogether. Any payout ratio over 60% may be a red flag. Youll have to dig into earnings statements to know if the dividend is at risk.

McDonalds currently has a 55% payout ratio.  It keeps 45% of its earnings to reinvest for continued growth. They shouldnt have a problem making dividend payments with that ratio. A long term investment in McDonalds should offer slow, steady stock growth with a 3% dividend yield for some time.

Dividends can play a big role in your investment strategy. Understanding them, their timing, and pitfalls is what it takes to be a good investor.