If we had published this article during the dotcom boom of the late 1990s, there's no doubt we would have been laughed at. 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.

Background on Dividends
A dividend is a cash payment from a company's earnings, 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 hopes 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 outperforming growth rates which outperform the market an impossible combination.

The changes witnessed in Microsoft in the last few years are a perfect illustration of what can happen when a firm's growth levels off. In Jan 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 in which to invest - 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.

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 try to achieve further growth will not offer the shareholder as high a return as a distribution in the form of dividends.