There are many benefits to investing in companies that pay dividends, especially if you plan to invest in them for the long-term. In addition to providing consistent income, many dividend-paying stocks are in defensive sectors that can weather economic downturns with reduced volatility. Dividend-paying companies also have substantial amounts of cash, and therefore, are usually strong companies with good prospects for long-term performance.

A dividend is a regular payment distributed from a company's earnings and paid to a class of its shareholders. Although cash dividends are the most common, dividends can also be issued as shares of stock or other property. But not all stocks pay dividends.

Key Takeaways

  • Dividend-paying stocks allow investors to profit in two ways: through appreciation in the price of the stock and through distributions made by the company.
  • In addition to providing consistent income, many dividend-paying stocks are in defensive sectors that can weather economic downturns with reduced volatility.
  • Dividend-paying companies also have substantial amounts of cash, and therefore, are usually strong companies with good prospects for long-term performance.

Dividend-paying stocks allow investors to profit in two ways. First, through appreciation in the price of the stock, and secondly, through distributions made by the company. Most companies pay dividends on a quarterly basis. Investors who are nearing retirement or are already retired many gravitate toward dividend stocks as a source of income.

How to Identify High Dividend-Yielding Stocks

When trying to identify stocks that pay high dividends, investors sometimes use a measure called the dividend yield. The dividend yield is a financial ratio, expressed as a percentage, that shows how much a company pays out in dividends each year relative to its stock price. The dividend yield is calculated by taking the annual dividend per share and dividing it by the price per share. For example, if a stock trades at $25 and a company's annual dividend is $1.50, the dividend yield is 6% ($1.50 divided by $25). You can also identify companies with high dividend yields by using a stock screening service.

Dividend Reinvestment Plans

It is common for people to reinvest the passive income from dividends back into the stock. Many companies have dividend reinvestment plans that allow investors to use dividends to buy more shares in the company. This allows investors to build a larger position in a company over time. Many companies do not charge commissions for these additional share purchases. Some even offer discounts of one to five percent off the share price. Companies may choose to offer dividend reinvestment plans because they benefit from having a base of long-term investors who are involved in the future of the company. 

Dividend Stocks Based in Defensive Sectors

Many companies that pay dividends are in defensive sectors. Defensive sectors are considered noncyclical and are therefore not as dependent on larger economic cycles. They are more likely to keep their value during periods of economic instability, and they generally have less volatility than the overall market, making them a good fit for more risk-averse investors. These companies can typically pay more than what investors could earn with U.S. Treasury bills or other types of bonds.

Common defensive sectors include food and beverage stocks, utility and housing companies, and pharmaceutical and healthcare companies. Even during times of economic uncertainty, demand for these goods doesn't typically go down because people still consume food and beverages, heat their homes, and demand medical care. Healthcare stocks like Johnson & Johnson (JNJ) are favorites of investors who are seeking dividends. On March 10, 2020, the dividend yield for Johnson & Johnson was 2.68%.

Companies That Pay Dividends Are Strong Performers

Many companies that pay dividends are strong performers, and they are able to make distributions to investors because they have a great deal of cash. Companies like Proctor & Gamble and Coca-Cola are two examples of strong performing companies that pay dividends. (Proctor & Gamble has a dividend yield of 2.47% and Coca-Cola has a dividend yield of 3.06%.)

In a Forbes article from 2015, contributor John Buckingham claimed that dividend-paying stocks have delivered better performance from 1927 to 2014. Dividend-paying stocks averaged 10.4% per year, while non-dividend-paying stocks only paid 8.5% per year during this time period. According to Buckingham, dividend-paying stocks also enjoyed lower volatility during this time period. The standard deviation for non-dividend-paying stocks was 30% during this time frame, while dividend-paying stocks only had a volatility of 18%.

Risks of Investing in Dividend-Paying Stocks

Despite all these benefits, there are still risks involved in investing in dividend-paying stocks. They are still subject to changing prices in the marketplace. If a company experiences a downturn in its market performance, there is always a chance it will reduce the amount of its dividend or eliminate its dividend entirely.