Many beginning investors do not understand what a dividend is — as it relates to an investment — particularly for an individual stock or mutual fund. A dividend is a payout of a portion of a company's profit to eligible stockholders, typically issued by a publicly traded company.

However, not all companies pay a dividend. Usually, the board of directors determines if a dividend is desirable for their particular company based on various financial and economic factors. Dividends are commonly paid in the form of cash distributions to the shareholders on a monthly, quarterly or yearly basis.

Shareholders of any given stock must meet certain requirements before receiving a dividend payout, or distribution. You must be a "shareholder of record" on or subsequent to a particular date designated by the company's board of directors in order to qualify for the dividend payout. Stocks are sometimes referred to as trading "ex-dividend," which simply means that they are trading on that particular day without dividend eligibility. If you buy and sell stock on its ex-dividend date, you will not receive the most current dividend payout.

Now that you have a basic definition of what a dividend is and how it is distributed, let's focus in more detail on what more you need to understand before making an investment decision.

What Is the Dividend Yield?

It may be counterintuitive, but as a stock's price increases, its dividend yield actually decreases. Dividend yield is a ratio of how much cash flow you are getting for each dollar invested in a stock. Many novice investors may incorrectly assume that a higher stock price correlates to a higher dividend yield. Let's delve into how dividend yield is calculated, so we can grasp this inverse relationship.

Dividends are normally paid on a per-share basis. If you own 100 shares of the ABC Corporation, the 100 shares is your basis for dividend distribution. Assume for the moment that ABC Corporation was purchased at $100 per share, which implies a total investment of $10,000. Profits at the ABC Corporation were unusually high, so the board of directors agrees to pay its shareholders $10 per share annually in the form of a cash dividend. So, as an owner of ABC Corporation for a year, your continued investment in ABC Corp result in $1,000 dollars of dividends. The annual yield is the total dividend amount ($1,000) divided by the cost of the stock ($10,000) which equals 10 percent.

If ABC Corporation was purchased at $200 per share instead, the yield would drop to five percent, since 100 shares now costs $20,000 (or your original $10,000 only gets you 50 shares, instead of 100). As illustrated above, if the price of the stock moves higher, then dividend yield drops and vice versa.

(For more, read Investment Valuation Ratios: Dividend Yield.)

Are Dividend-Paying Stocks Good Investments?

The real question one has to ask is whether dividend-paying stocks make a good overall investment. Dividends are derived from a company's profits, so it is fair to assume that in most cases, dividends are generally a sign of financial health. From an investment strategy perspective, buying established companies with a history of good dividends adds stability to a portfolio. Your $10,000 investment in ABC Corporation, if held for one year, will be worth $11,000, assuming the stock price after one year is unchanged. Moreover, if ABC Corporation is trading at $90 share a year after you purchased for $100 a share, your total investment after receiving dividends is still break even ($9,000 stock value + $1,000 in dividends).

This is the appeal of buying stocks with dividends — it helps cushion declines in the actual stock prices, but also presents an opportunity for stock price appreciation coupled with a steady stream of income from dividends. This is why many investing legends such as John Bogle, Warren Buffett and Benjamin Graham advocate buying stocks that pay dividends as a critical part of the total "investment" return of an asset.

The Risks to Dividends

During the financial meltdown in 2008-2009, almost all of the major banks either slashed or eliminated their dividend payouts. These companies were known for consistent, stable dividend payouts each quarter for literally hundreds of years. Despite their storied histories, many dividends were cut.

In other words, dividends are not guaranteed, and are subject to macroeconomic as well as company-specific risks. Another potential downside to investing in dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders. There are some exceptions, but high-growth companies usually do not pay sizable amounts of dividends to its shareholders even if they have significantly outperformed the vast majority of stocks over time. Growth companies tend to spend more dollars on research and development, capital expansion, retaining talented employees and/or mergers and acquisitions. For these companies, all earnings are considered retained earnings, and are reinvested back into the company instead of issuing a dividend to shareholders.

It is equally important to beware of companies with extraordinarily high yields. As we have learned, if a company's stock price continues to decline, its yield goes up. Many rookie investors get teased into purchasing a stock just on the basis of a potentially juicy dividend. There is no specific rule of thumb in relation to how much is too much in terms of a dividend payout.

The average dividend yield on S&P 500 index companies that pay a dividend historically fluctuates somewhere between 2 and 5 percent, depending on market conditions. In general, it pays to do your homework on stocks yielding more than 8 percent to find out what is truly going on with the company. Doing this due diligence will help you decipher those companies that are truly in financial shambles from those that are temporarily out of favor, and therefore present a good investment value proposition.

(Find out How and Why Do Companies Pay Dividends?)

The Bottom Line

Dividends are really a discretionary distribution of profits which a company's board of directors gives its current shareholders. It is typically a cash payout to investors at least once a year, but sometimes quarterly. Stocks and mutual funds that distribute dividends are likely on sound financial ground, but not always. Investors, however, should be aware of extremely high yields, since there is an inverse relationship between stock price and dividend yield and the distribution might not be sustainable. Also, stocks that pay dividends typically provide stability to a portfolio, but do not usually outperform high-quality growth stocks.

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