Dividend Stocks: How They Work and How to Invest

Dividend Stocks: How They Work and How to Invest

When putting together a stock investing strategy, why not consider investing in dividend stocks? Dividend stocks typically offer a beneficial one-two punch: regular dividend payments and consistent appreciation of stock prices over time.

But what are "dividend stocks?" Investing in dividend stocks simply means that you buy shares of publicly traded companies that pay dividends with the goal of earning a regular payout at certain intervals. As your holdings gain value, you also have the opportunity to sell your dividend-paying stocks for profit. However, as many investors realize, it’s a savvy investment decision to hold onto dividend stocks for the long term so you benefit from the cash flow they can offer over consecutive years in the market.

Let’s walk through how dividend stocks work, examples of dividend stocks, how to invest in dividend stocks, how dividend stocks are taxed, and dividend investment strategies you may want to consider.

How Dividend Stocks Work

You receive dividend payments based on each share of stock you own. Here’s a simple example:

Let’s say you buy 50 shares of ABC stock and the company pays fifty cents in cash dividends annually. You’d receive $25 in annual dividends in one year from that particular company.

Why do companies pay dividends? They do so in order to share profits with investors based on company earnings. They do this in order to encourage investors to “stick with them” by urging them to continue to invest in the company’s stock.

You can do what you want with your dividend returns. You can reinvest your dividends back into the company to buy more shares, called dividend reinvestment, which helps your investments compound — this means that interest builds on interest. You can also choose to spend the money you receive or invest in another type of investment altogether, such as a completely different exchange-traded fund (ETF) or mutual fund. 

Companies base their dividends on four main “dates,” called the declaration date, the ex-dividend date, the record date and the payment date.

  • Declaration date: The declaration date is the date in which the board of directors of a company authorizes dividend payments to go to shareholders.
  • Ex-dividend date: The ex-dividend date, also called the ex-date, decides who of the company’s shareholders is eligible to receive dividends. If you own even one share of stock by the ex-date, you’ll qualify to receive the payment. However, if you buy a dividend stock on or after the ex-date, you won’t receive a dividend payment. Here’s a tricky scenario: Let’s say you own the stock on the ex-date but sell it before the payment date. Do you think you’ll still receive the dividend? The answer is yes.
  • Record date: The record date is the final date that you must be considered a shareholder by the company in order to receive the dividend. The company sets this date in order to make it extremely clear as to who can or cannot receive a dividend payout.
  • Payment date: Companies also declare a payment date, which is the date that shareholders will receive payment by companies.

There are different ways to receive dividends — not all companies pay cash dividends, which means that you receive cash in return for your shares. Companies might also “pay up” by offering stock dividends, which means companies offer shareholders extra shares of stock in lieu of cold, hard cash.

Companies might also offer special dividends, or dividends that are like a little “extra surprise” — these pleasant dividends usually crop up when a company has calculated excellent earnings or through a sale of a subsidiary or another profit.

A company might even give you real estate or another type of physical asset instead of cash or cash equivalents in the form of property dividends. You might even get a choice about whether you receive cash or company stock through a scrip dividend.

There are other types of dividends available. Know the differences between the types of dividends you may receive from a particular company.

Examples of Dividend Stocks

What are some examples of dividend stocks? When you’re a beginner investor, sometimes you just want a list to pick from!

Here’s a quick list of the best dividend stocks 2022:

As you can see, the dividend stocks list contains a list of companies you’ve heard of, which can bring comfort if you’re a beginner investing in the stock market for the first time. In fact, this is a special list because it comes from a list of companies called the “Dividend Aristocrats,” which are well-known companies part of the S&P 500 index that pay dividends. The S&P 500 index tracks the performance of the 500 largest companies listed on stock exchanges in the U.S. To qualify as part of this elite group, the Dividend Aristocrats must have a track record of increasing their annual total dividend per share for 25 straight years in a row, have a market capitalization of at least $3 billion as well as a daily trading amount of at least $5 million. 

How to Invest in Dividend Stocks

Naturally, you want to have the option of the best dividends (and the best stocks) available to you when you invest. Let’s take a look at the steps you can take to invest in dividend stocks.

Step 1: Determine your investment objectives.

What are your goals? Do you want to make sure your IRA is plumb full so you’ll have continued earnings growth through dividend increases in a diversified portfolio, ready for you when you need to tap into your nest egg?

Or maybe you’re not worried about a retirement plan right now. Do you want dividends to help you pay for everyday expenses right now, such as rent, your mortgage or groceries?

The research you’ll do based on these goals will help guide you toward the right dividend investments for your needs. First and foremost, it’s a good idea to consider your goals.

Only then can you determine which individual stocks fit your goals, timeline and show the most promise.

Step 2: Evaluate factors such as dividend yield and dividend growth.

You might want to bring out your calculator next once you zero in on some companies that you single out for investing opportunities.

You want to learn about the dividend yield of each investment you’re considering.

Dividend yield equals the annual dividend per share divided by the stock's price per share. For example, let’s say a company offers an annual dividend of $1.25 and the stock trades at $30. In this case, the dividend yield is 4% ($1.25/$30).

You can calculate the dividend yield in order to consider the dividend growth potential of your potential investments.

Finally, don’t forget to look at the fundamentals of each company you’re considering. Past performance doesn’t always guarantee future performance, but you can gauge the solidity of each dividend stock you’re considering based on a number of factors beyond the dividend payout ratio.

The company’s annual letter to shareholders, balance sheets, SEC filings, quarterly earnings updates and recent news can all give you clues as to whether you should invest in a particular company.

Step 3: Set up your brokerage account.

If you don’t already have a brokerage account set up, you can set one up quickly with online brokerages such as Fidelity or Vanguard. If you’re not comfortable setting up a brokerage account on your own or going the semi-DIY route with a robo advisor, you may want to consider getting a financial advisor on your side. No matter which route you choose to go, it shouldn’t take too long to set up your brokerage account. You’ll need to provide basic information, such as your name, address, bank account information and your Social Security number (to verify your identity).

Step 4: Invest in the dividend stock(s) of your choice.

Once you complete your research, it’s time to buy. Choose the dividend stock of your choice, choose the number of shares you want to purchase and choose your order type. You may choose from market order, which means that at the best available price, you can buy or sell a stock; a limit order, which is a request to buy or sell at a specific price or better; a stop-loss order, which means that once a stock gets to a certain price, a market order kicks in and the order is filled at that price. Finally, a stop-limit order means that once a stock reaches the stop price, the trade goes into “limit order mode” and fills up to the specified price limits.

Once you’ve purchased your stocks, don’t just forget about them. Monitor them for volatility, returns and more.

Bottom Line

Dividend investing is a great personal finance strategy. In fact, it’s one of the most popular passive income investment strategies and one that Warren Buffett employs over and over. Buffett, arguably the most famous investor of all time, has invested in dozens and dozens of dividend stocks over his lifetime, including Johnson & Johnson (NYSE: JNJ), Coca-Cola Consolidated Inc. (NASDAQ: COKE), Bristol-Myers Squibb Company (NYSE: BMY) and more.

If you’re looking for a way to invest in growth and need an investment strategy in which you can continually reap the benefits, consider dividend investing.

Find out why slow and steady wins the race with DividendStocks.com.