Dividend Stocks: What They Are & How They Work

Investing for income means investing in stocks that provide you with regular cash payments (dividends). Dividend stocks may not be known to offer stellar growth potential, but they’re good for a steady infusion of cash. If you have a low tolerance for risk or if your investment goal is anything less than long-term, dividend stocks are a better bet than growth stocks. 

Long-term, conservative investors who need income in their situations can also benefit from dividend stocks because they have a good track record of keeping pace with inflation (versus fixed-income investments, such as bonds).

The bottom line is that I like dividend-paying stocks, and they deserve a spot in a variety of portfolios. In this chapter, I explain the basics of dividend stocks, show you how to analyze dividend stocks with a few handy formulas, and describe several typical dividend stocks.

The Basics of Dividend Stocks

When people talk about income from stocks, they usually refer to dividends. Dividends are simply money paid to the owner of the stock. Dividend stocks are bought primarily for the income, not the growth potential.

Dividends and interest are sometimes confused. The difference between dividends and interest is that dividends are paid to owners, while interest is paid to creditors. Stock investors are co-owners of the companies they invest in and are entitled to dividends when they are issued. When you open an account with a bank, you become a creditor. Your money is lent by the bank and you receive interest on it.

Dividends are usually paid quarterly but are stated as annual figures. For example, if a stock pays a quarterly dividend of $4, you will probably receive $1. For example, if you own 200 shares, you will receive $800 per year (if the dividend does not change), or $200 per quarter. If you hold the stock long enough, you will receive a dividend check every three months. A dividend stock pays a higher dividend than average (usually 4% or more).

The amount of the dividend is not guaranteed – it can go up or down, and in extreme cases, the dividend can be suspended or canceled. The majority of companies that pay dividends do so indefinitely and even increase them from time to time. Dividend increases have historically matched (or exceeded) inflation.

Who Are Dividend Stocks For?

What type of person is best suited to dividend stocks? Many investors can benefit from dividend stocks, but these individuals are especially well-suited:

  • Conservative and novice investors: A conservative investor prefers a steady but slow approach to growing their money while receiving regular dividend checks. Inexperienced investors can also benefit from dividend stocks.
  • Retirees: Investing in growth should be done for long-term goals while investing in income should be done for short-term goals. The majority of retirees are more concerned with regular income that can keep pace with inflation than they are with investment growth in their portfolios.
  • Dividend reinvestment plan (DRP) investors: Investors who like to compound their money through dividend-reinvestment plans should consider dividend stocks.

Given recent economic trends and conditions for the foreseeable future, I think that dividends should be a mandatory part of the stock investor’s wealth-building approach.

This is especially true for those in or approaching retirement. Investing in stocks that have a reliable track record of increasing dividends is now easier than ever. There are, in fact, exchange-traded funds (ETFs) that are focused on stocks with a long and consistent track record of raising dividends (typically on an annual basis). 

ETFs such as the iShares Core High Dividend ETF (symbol HDV) hold 45–50 companies that have raised their dividends every year for ten years or longer. 

Advantages of Dividend Stocks

Dividend stocks tend to be among the least volatile of all stocks, and many investors view them as defensive stocks. Defensive stocks are stocks of companies that sell goods and services that are generally needed no matter what shape the economy is in. (Don’t confuse defensive stocks with defense stocks, which specialize in goods and equipment for the military.) 

Food, beverage, and utility companies are great examples of defensive stocks. Even when the economy is experiencing tough times, people still need to eat, drink, and turn on the lights. Companies that offer relatively high dividends also tend to be large firms in established, stable industries.

Some industries in particular are known for high-dividend stocks. Utilities (such as electric, gas, and water), real estate investment trusts (REITs), and the energy sector (oil and gas royalty trusts) are places where you definitely find dividend stocks. Yes, you can find high-dividend stocks in other industries, but you find a higher concentration of them in these industries.

Disadvantages of Dividend Stocks

Before you say, “Dividend stocks are great! I’ll get my checkbook and buy a batch right now,” take a look at the following potential disadvantages (ugh!). Dividend stocks do come with some fine print.


Dividend stocks can go down as well as up, just as any stock can. The factors that affect stocks in general — politics, megatrends, different kinds of investment risks, and so on — affect dividend stocks, too. Fortunately, dividend stocks don’t get hit as hard as other stocks when the market is declining because high dividends tend to act as a support to the stock price. Therefore, dividend stocks’ prices usually fall less dramatically than other stocks’ prices in a declining market.

Interest-rate sensitivity

Dividend stocks can be sensitive to rising interest rates. When interest rates go up, other investments (such as corporate bonds, U.S. Treasury securities, and bank certificates of deposit) are more attractive. When your dividend stock yields 4 percent and interest rates go up to 5 percent, 6 percent, or higher, you may think, “Hmm. Why settle for a 4 percent yield when I can get 5 percent or better elsewhere?” As more and more investors sell their low-yield stocks, the prices for those stocks fall.

Another point to note is that rising interest rates may hurt the company’s financial strength. If the company has to pay more interest, that may affect the company’s earnings, which in turn may affect the company’s ability to continue paying dividends.

Dividend-paying companies that experience consistent falling revenues tend to cut dividends. In this case, consistent means two or more years.

The effect of inflation

Although many companies raise their dividends on a regular basis, some don’t. Or if they do raise their dividends, the increases may be small. If income is your primary consideration, you want to be aware of this fact. If you’re getting the same dividend year after year and this income is important to you, rising inflation becomes a problem.

Say that you have XYZ stock at $10 per share with an annual dividend of 30 cents (the yield is 30 cents divided by $10, or 3 percent). If you have a yield of 3 percent two years in a row, how do you feel when inflation rises 6 percent one year and 7 percent the next year? Because inflation means your costs are rising, inflation shrinks the value of the dividend income you receive.

Fortunately, studies show that in general, dividends do better in inflationary environments than bonds and other fixed-rate investments. Usually, the dividends of companies that provide consumer staples (food, energy, and so on) meet or exceed the rate of inflation.


The government usually taxes dividends as ordinary income. Find out from your tax person whether potentially higher tax rates on dividends are in effect for the current or subsequent tax year.

How to Choose Dividend Stocks

As I explain in the preceding section, even conservative income investors can be confronted with different types of risk. Fortunately, this section helps you carefully choose dividend stocks so that you can minimize potential disadvantages.

Look at dividend stocks in the same way you do growth stocks when assessing the financial strength of a company. Getting nice dividends comes to a screeching halt if the company can’t afford to pay them. If your budget depends on dividend income, then monitoring the company’s financial strength is that much more important.

1. Pinpointing your needs first

You choose dividend stocks primarily because you want or need the income now. As a secondary point, dividend stocks have the potential for steady, long-term appreciation. So if you’re investing for retirement needs that won’t occur for another 20 years, maybe dividend stocks aren’t suitable for you — a better choice may be to invest in growth stocks because they’re more likely to grow your money faster over a lengthier investment term. 

If you’re certain you want dividend stocks, do a rough calculation to figure out how big a portion of your portfolio you want dividend stocks to occupy. Suppose that you need $25,000 in investment income to satisfy your current financial needs. 

If you have bonds that give you $20,000 in interest income and you want the rest to come from dividends from dividend stocks, you need to choose stocks that pay you $5,000 in annual dividends. If you have $100,000 left to invest, you need a portfolio of dividend stocks that yield 5 percent ($5,000 divided by $100,000 equals a yield of 5 percent; I explain yield in more detail in the following section).

You may ask, “Why not just buy $100,000 of bonds (for instance) that may yield at least 5 percent?” Well, if you’re satisfied with that $5,000, and inflation for the foreseeable future is 0 or considerably less than 5 percent, then you have a point. 

Unfortunately, inflation (low or otherwise) will probably be with us for a long time. Fortunately, the steady growth (of their dividends) that dividend stocks provide is a benefit to you.

If you have dividend stocks and don’t have any immediate need for the dividends, consider reinvesting the dividends in the company’s stock.

Every investor is different. If you’re not sure about your current or future needs, your best choice is to consult with a financial planner.

2. Checking out yield

Because dividend stocks pay out dividends — income — you need to assess which stocks can give you the highest income. How do you do that? The main thing to look for is yield, which is the percentage rate of return paid on a stock in the form of dividends. Looking at a stock’s dividend yield is the quickest way to find out how much money you’ll earn versus other dividend-paying stocks (or even other investments, such as a bank account).

The dividend yield is calculated in the following way:

Dividend yield = Dividend income divided by Stock investment

Don’t stop scrutinizing stocks after you acquire them. You may make a great choice that gives you a great dividend, but that doesn’t mean the stock will stay that way indefinitely. Monitor the company’s progress for as long as the stock is in your portfolio.

Examining changes in yield

Most people have no problem understanding yield when it comes to bank accounts. If I tell you that my bank certificate of deposit (CD) has an annual yield of 3.5 percent, you can easily figure out that if I deposit $1,000 in that account, a year later I’ll have $1,035 (slightly more if you include compounding). The CD’s market value in this example is the same as the deposit amount — $1,000. That makes it easy to calculate.

How about stocks? When you see a stock listed in the financial pages, the dividend yield is provided, along with the stock’s price and annual dividend. The dividend yield in the financial pages is always calculated as if you bought the stock on that given day. Just keep in mind that based on supply and demand, stock prices change every business day (virtually every minute!) that the market’s open, so the yield changes daily as well. So keep the following two things in mind when examining yield:

  • The yield listed in the financial pages may not represent the yield you’re receiving.
  • Stock price affects how good of an investment the stock may be. Another way to look at yield is by looking at the investment amount.

Comparing yield between different stocks

All things being equal, choosing Smith Co. or Jones Co. is a coin toss. It’s looking at your situation and each company’s fundamentals and prospects that will sway you. What if Smith Co. is an auto stock (similar to General Motors in 2008) and Jones Co. is a utility serving the Las Vegas metro area? Now what? In 2008, the automotive industry struggled tremendously, but utilities were generally in much better shape. In that scenario, Smith Co.’s dividend is in jeopardy, whereas Jones Co.’s dividend is more secure.

3. Looking at a stock’s payout ratio

You can use the payout ratio to figure out what percentage of a company’s earnings is being paid out in the form of dividends (earnings = sales – expenses). Keep in mind that companies pay dividends from their net earnings. Therefore, the company’s earnings should always be higher than the dividends the company pays out. Here’s how to figure a payout ratio:

Dividend (per share) divided by Earnings (per share) = Payout ratio

Say that the company CashFlow Now, Inc. (CFN), has annual earnings (or net income) of $1 million. Total dividends are to be paid out of $500,000, and the company has 1 million outstanding shares. Using those numbers, you know that CFN’s earnings per share (EPS) is $1 ($1 million in earnings divided by 1 million shares) and that it pays an annual dividend of 50 cents per share ($500,000 divided by 1 million shares). 

The dividend payout ratio is 50 percent (the 50-cent dividend is 50 percent of the $1 EPS). This number is a healthy dividend payout ratio because even if CFN’s earnings fall by 10 percent or 20 percent, plenty of room still exists to pay dividends.

If you’re concerned about your dividend income’s safety, regularly watch the payout ratio. The maximum acceptable payout ratio should be 80 percent, and a good range is 50 to 70 percent. A payout ratio of 60 percent or lower is considered very safe (the lower the percentage, the safer the dividend).

When a company suffers significant financial difficulties, its ability to pay dividends is compromised. (Good examples of stocks that have had their dividends cut in recent years due to financial difficulties are mortgage companies in the wake of the housing bubble bursting and the fallout from the subprime debt fiasco. 

Mortgage companies received less and less income due to mortgage defaults, which forced the lowering of dividends as cash inflow shrunk.) So if you need dividend income to help you pay your bills, you better be aware of the dividend payout ratio.

4. Studying a company’s bond rating

Actually, a company’s bond rating is very important to dividend stock investors. The bond rating offers insight into the company’s financial strength. Bonds get rated for quality for the same reasons that consumer agencies rate products like cars or toasters. 

Standard & Poor’s (S&P) is the major independent rating agency that looks into bond issuers. S&P looks at the bond issuer and asks, “Does this bond issuer have the financial strength to pay back the bond and the interest as stipulated in the bond indenture?”

To understand why this rating is important, consider the following:

  • A good bond rating means that the company is strong enough to pay its obligations. These obligations include expenses, payments on debts, and declared dividends. If a bond rating agency gives the company a high rating (or if it raises the rating), that’s a great sign for anyone holding the company’s debt or receiving dividends.
  • If a bond rating agency lowers the rating, that means the company’s financial strength is deteriorating — a red flag for anyone who owns the company’s bonds or stock. A lower bond rating today may mean trouble for the dividend later on.
  • A poor bond rating means that the company is having difficulty paying its obligations. If the company can’t pay all its obligations, it has to choose which ones to pay. More times than not, a financially troubled company chooses to cut dividends or (in a worst-case scenario) not pay dividends at all.

The highest rating issued by S&P is AAA. The grades AAA, AA, and A are considered investment grades, or of high quality. Bs and Cs indicate a poor grade, and anything lower than that is considered very risky (the bonds are referred to as junk bonds). 

5. Diversifying your stocks

If most of your dividend income is from stock in a single company or single industry, consider reallocating your investment to avoid having all your eggs in one basket. 

Concerns about diversification apply to dividend stocks as well as growth stocks. If all your dividend stocks are in the electric utility industry, then any problems in that industry are potential problems for your portfolio as well.

Typical Dividend Stocks

Although virtually every industry has stocks that pay dividends, some industries have more dividend-paying stocks than others. You won’t find too many dividend stocks in the computer or biotech industries, for instance. 

The reason is that these types of companies need a lot of money to finance expensive research and development (R&D) projects to create new products. Without R&D, the company can’t create new products to fuel sales, growth, and future earnings. Computer, biotech, and other innovative industries are better for growth investors. Keep reading for the scoop on stocks that work well for income investors.

1. Utilities

Utilities generate a large cash flow. (If you don’t believe me, look at your gas and electric bills!) Cash flow includes money from income (sales of products and/or services) and other items (such as the selling of assets, for example). This cash flow is needed to cover expenses, loan payments, and dividends. 

Utilities are considered the most common type of dividend stocks, and many investors have at least one utility company in their portfolio. Investing in your own local utility isn’t a bad idea — at least it makes paying the utility bill less painful.

Before you invest in a public utility, consider the following:

  • The utility company’s financial condition: Is the company making money, and are its sales and earnings growing from year to year? Make sure the utility’s bonds are rated A or higher
  • The company’s dividend payout ratio: Because utilities tend to have a good cash flow, don’t be too concerned if the ratio reaches 70 percent. From a safety point of view, however, the lower the rate, the better.
  • The company’s geographic location: If the utility covers an area that’s doing well and offers an increasing population base and business expansion, that bodes well for your stock. A good resource for researching population and business data is the U.S. Census Bureau.

2. Real estate investment trusts (REITs)

Real estate investment trusts (REITs) are a special breed of stock. A REIT is an investment that has elements of both a stock and a mutual fund (a pool of money received from investors that’s managed by an investment company). To learn more, see our guide on how to invest in REITs.

A REIT resembles a stock in that it’s a company whose stock is publicly traded on the major stock exchanges, and it has the usual features that you expect from a stock — it can be bought and sold easily through a broker, income is given to investors as dividends, and so on.

A REIT resembles a mutual fund in that it doesn’t make its money selling goods and services; it makes its money by buying, selling, and managing an investment portfolio of real estate investments. It generates revenue from rents and property leases, as any landlord does. In addition, some REITs own mortgages, and they gain income from the interest.

REITs are called trusts only because they meet the requirements of the Real Estate Investment Trust Act of 1960. This act exempts REITs from corporate income tax and capital gains taxes as long as they meet certain criteria, such as dispensing 90 percent of their net income to shareholders. This provision is the reason why REITs generally issue generous dividends. Beyond this status, REITs are, in a practical sense, like any other publicly-traded company.

The main advantages to investing in REITs include the following:

  • Unlike other types of real estate investing, REITs are easy to buy and sell. You can buy a REIT by making a phone call to a broker or visiting a broker’s website, just as you can to purchase any stock.
  • REITs have higher-than-average yields. Because they must distribute at least 90 percent of their income to shareholders, their dividends usually yield a return of 5 to 10 percent.
  • REITs involve a lower risk than the direct purchase of real estate because they use a portfolio approach diversified among many properties. Because you’re investing in a company that buys the real estate, you don’t have to worry about managing the properties — the company’s management does that on a full-time basis. Usually, the REIT doesn’t just manage one property; it’s diversified in a portfolio of different properties.
  • Investing in a REIT is affordable for small investors. REIT shares usually trade in the $10 to $40 range, meaning that you can invest with very little money.

REITs do have disadvantages. Although they tend to be diversified with various properties, they’re still susceptible to risks tied to the general real estate sector. Real estate investing reached manic, record-high levels during 2000–2007, which meant that a downturn was likely. Whenever you invest in an asset (like real estate or REITs in recent years) that has already skyrocketed due to artificial stimulants (in the case of real estate, very low interest rates, and too much credit and debt), the potential losses can offset any potential (unrealized) income.

When you’re looking for a REIT to invest in, analyze it the way you’d analyze a property. Look at the location and type of property. If shopping malls are booming in California and your REIT buys and sells shopping malls in California, then you’ll probably do well. However, if your REIT invests in office buildings across the country and the office building market is overbuilt and having tough times, you’ll have a tough time, too.

Many of the dangers of the “housing bubble” have passed, and investors can start looking at real estate investments (such as REITs) with less anxiety. However, choosing REITs with a view toward quality and strong fundamentals (location, potential rents, and so forth) is still a good idea.

3. Good energy: Royalty trusts

In recent years, the oil and gas sector has generated much interest as people and businesses experience much higher energy prices. Due to a variety of bullish factors, such as increased international demand from China and other emerging industrialized nations, oil and gas prices have zoomed to record highs. Some income investors have capitalized on this price increase by investing in energy stocks called royalty trusts.

Royalty trusts are companies that hold assets such as oil-rich and/or natural gas-rich land and generate high fees from companies that seek access to these properties for exploration. The fees paid to the royalty trusts are then disbursed as high dividends to their shareholders. During 2015, royalty trusts sported yields in the 6 to 10 percent range, which is very enticing given how low the yields have been in this decade for other investments like bank accounts and bonds.

Although energy has been a hot field in recent years and royalty trusts have done well, keep in mind that their payout ratios are very high (often in the 90 to 100 percent range), so dividends will suffer should their cash flow shrink.

Final Words

Over time, dividends can have a significant impact on your portfolio. Besides generating income during retirement or earlier, they can also be reinvested to increase total investment returns. As part of your long-term investment plan, consider owning dividend-paying companies through a low-cost fund or ETF.

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