During the dotcom boom of the late 1990s, the notion of dividend investing was laughable. Back then, everything was going up in double-digit percentages, and nobody wanted to fool around with the meager 2-3% gain from dividends. After all, we were in the "new economy": the rules had changed and companies that paid dividends were "too old economy".

As Bob Dylan once sang, "The times, they are a-changin'." After the bull market of the '90s ended, the fickle mob once again found dividends attractive. For many investors, dividend-paying stocks have come to make a lot of sense. In this article, we'll explain what dividends are and how you can make them work for you. (For background reading, see The Power Of Dividend Growth.)

Background on Dividends
A dividend is a cash payment from a company's earnings; it is announced by a company's board of directors and distributed among stockholders. In other words, dividends are an investor's share of a company's profits, given to him or her as a part-owner of the company. Aside from option strategies, dividends are the only way for investors to profit from ownership of stock without eliminating their stake in the company.

When a company earns profits from operations, management can do one of two things with the profits. It can choose to retain them - essentially reinvesting them into the company with the hope of creating more profits and thus further stock appreciation. The other alternative is to distribute a portion of the profits to shareholders in the form of dividends. (Management can also opt to repurchase some of its own shares - a move that would also benefit shareholders. Read more about it in The Lowdown on Stock Buybacks.)

A company must keep growing at an above-average pace to justify reinvesting in itself rather than paying a dividend. Generally speaking, when a company's growth slows, its stock won't climb as much, and dividends will be necessary to keep shareholders around. This growth slowdown happens to virtually all companies after they attain a large market capitalization. A company will simply reach a size at which it no longer has the potential to grow at annual rates of 30-40% like a small cap, regardless of how much money is plowed back into it. At a certain point, the law of large numbers makes a mega-cap company and growth rates that outperform the market an impossible combination.

The changes witnessed in Microsoft (Nasdaq:MSFT) in 2003 are a perfect illustration of what can happen when a firm's growth levels off. In January 2003, the company finally announced that it would pay a dividend: Microsoft had so much cash in the bank that it simply couldn't find enough worthwhile projects to spend it on - you can't be a high-flying growth stock forever!

The fact that Microsoft started to pay dividends did not signal the company's demise; it simply indicated that Microsoft had become a huge company and had entered a new stage in its life cycle, which meant it probably would not be able to double and triple at the pace it once did. (To learn more about this process, read The Stages Of Industry Growth.)

Dividends Won't Mislead You
By choosing to pay dividends, management is essentially conceding that profits from operations are better off being distributed to the shareholders than being put back into the company. In other words, management feels that reinvesting profits to achieve further growth will not offer the shareholder as high a return as a distribution in the form of dividends.

There is another motivation for a company to pay dividends: a steadily increasing dividend payout is viewed as a strong indication of a company's continuing success. The great thing about dividends is that they can't be faked. They are either paid or not paid, increased or not increased.

This isn't the case with earnings, which are basically an accountant's best guess of a company's profitability. All too often, companies must restate their past reported earnings because of aggressive accounting practices, and this can cause considerable trouble for investors, who may have already based future stock price predictions on these (unreliable) historical earnings. (To learn more about evaluating earnings, read Earnings: Quality Means Everything.)

Expected growth rates are also unreliable. A company can talk a big game about wonderful growth opportunities that will pay off several years down the road, but there are no guarantees that it will make the most of its reinvested earnings. When a company's robust plans for the future (which impact its share price today) fail to materialize, your portfolio will very likely take a hit.

However, you can rest assured that no accountant can restate dividends and take back your dividend check. Moreover, dividends can't be squandered away by the company on business expansions that don't pan out. The dividends you receive from your stocks are 100% yours. You can use them to do anything you like: pay down your mortgage, spend it as discretionary income or buy the stock of a company you think has better growth prospects.

Who Determines Dividend Policy?
The company's board of directors decides what percentage of earnings will be paid out to shareholders, and then puts the remaining profits back into the company. Although dividends are usually dispersed quarterly, it is important to remember that the company is not obligated to pay a dividend every single quarter. In fact, the company can stop paying a dividend at any time, but this is rare, especially for a firm with a long history of dividend payments. (To learn more about this problem, read Is Your Dividend At Risk?)

If people were used to getting their quarterly dividends from a mature company, a sudden stop in payments to investors would be akin to corporate financial suicide. Unless the decision to discontinue dividend payments was backed by some kind of strategy shift, say investing all retained earnings into robust expansion projects, it would indicate that something was fundamentally wrong with the company. For this reason, the board of directors will usually go to great lengths to keep paying at least the same dividend amount.

How Stocks That Pay Dividends Resemble Bonds
When assessing the pros and cons of dividend-paying stocks, you will also want to consider their volatility and share price performance as compared to those of outright growth stocks that pay no dividends.

Because public companies generally face adverse reactions from the marketplace if they discontinue or reduce their dividend payments, investors can be reasonably certain they will receive dividend income on a regular basis for as long as they hold their shares. Therefore, investors tend to rely on dividends in much the same way that they rely on interest payments from corporate bonds and debentures.

Since they can be regarded as quasi-bonds, dividend-paying stocks tend to exhibit pricing characteristics that are moderately different from those of growth stocks. This is because they provide regular income, similar to a bond, but still provide investors with the potential to benefit from share price appreciation if the company does well.

Investors looking for exposure to the growth potential of the equity market, combined with the safety of the (moderately) fixed income provided by dividends, should consider adding stocks with high dividend yields to their portfolio. A portfolio with dividend-paying stocks is likely to see less price volatility than a growth stock portfolio. (This is why dividends are often considered to be a good recessionary investment. Read Dividend Yield For The Downturn to learn more.)

A company can't keep growing forever. When it reaches a certain size and exhausts its growth potential, distributing dividends is perhaps the best way for management to ensure that shareholders receive a return from the company's earnings. A dividend announcement may be a sign that a company's growth has slowed, but it is also evidence of a sustainable capacity to make money. This sustainable income will likely produce some price stability when paid out regularly as dividends. Best of all, the cash in your hand is proof that the earnings are really there, and you can reinvest or spend them as you see fit.

To read more on this subject, see Dividend Facts You May Not Know.

Related Articles
  1. Investing Basics

    An Example of Dividends in Arrears

    Learn about the concept of dividends in arrears and which shares of stock guarantee payment of accrued dividends even if the company doesn't turn a profit.
  2. Investing Basics

    Reinvesting Dividends Pays in the Long Run

    Find out why dividend reinvestment is one of the easiest ways to grow wealth, including how this tactic can increase your investment income over time.
  3. Stock Analysis

    If You Had Invested Right After Costco's IPO

    Find out how much your investment would be worth if you had invested $1,000 during Costco's IPO and how much you would have received in dividends.
  4. Stock Analysis

    If You Had Invested Right After Coca-Cola's IPO

    Discover how one $40 share, with dividend reinvestment, over 90 years ago in the Coca-Cola Company would have made you a multimillionaire today.
  5. Stock Analysis

    If You Had Invested Right After Cisco's IPO

    Discover how Cisco became one of the greatest IPOs in history during the 1990s and how it continues to innovate and move forward today.
  6. Stock Analysis

    If You Had Invested Right After Amgen's IPO

    Discover how $1,000 invested in Amgen during its initial public offering (IPO), without reinvesting dividends, would be worth over $427,000 as of November 2015.
  7. Stock Analysis

    The Biggest Risks of Investing in ConocoPhillips Stock

    Understand the risks of investing in ConocoPhillips stock. Learn about how there is a risk of a dividend cut due to lower prices for crude oil.
  8. Investing

    6 High Value and High Dividend Stocks

    Are you looking for stocks that offer regular dividends payments and will appreciate? Here are the top stocks that offer the best of both.
  9. Investing

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  10. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  1. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  2. What are the dividend reinvestment options for a mutual fund?

    There are two primary choices for how investors can choose to handle dividend distributions made by mutual funds that they ... Read Full Answer >>
  3. Do mutual funds pay dividends or interest?

    Depending on the type of investments included in the portfolio, mutual funds may pay dividends, interest, or both. Types ... Read Full Answer >>
  4. Should I sell my shares if a company suspends its dividend?

    Since 2008, when the Federal Reserve slashed interest rates to zero and then kept them there indefinitely, dividend-paying ... Read Full Answer >>
  5. Do interest rates increase during a recession?

    Interest rates rarely increase during a recession. Actually, the opposite tends to happen; as the economy contracts, interest ... Read Full Answer >>
  6. Do hedge funds pay dividends?

    Hedge funds rarely pay dividends to the accredited investors who invest directly in them. Instead, these investors share ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  2. Bullish Engulfing Pattern

    A chart pattern that forms when a small black candlestick is followed by a large white candlestick that completely eclipses ...
  3. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  4. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  5. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
Trading Center