What is a dividend, and what should investors look for when choosing dividend stocks?

How dividends are paid

Dividends are paid on a regular basis, often quarterly, to share profits with stockholders. They can be paid out as either cash or in the form of additional stock.

Shareholders will receive a dollar amount or percentage for each share they own. For example, if the company pays a $1.50 cash dividend per share, and you own 40 shares, you’ll receive $60 over the year.

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Dividends can be a win-win for investors and companies

Not every company pays shareholder dividends — a lot of them hold onto their profits and reinvest in the company instead.

Shareholders who want to receive dividends need to buy the stock before what’s called the ex-dividend date — essentially a cutoff date that ensures they’re eligible for the payments. Shareholders who might be considering selling their stock shares must hold them until the ex-dividend date if they want to receive their dividends.

The dividend yield, the amount a company pays out per share, is set by the board of directors, which also has to approve every dividend payment.

There are two main reasons for companies to issue dividends. They reward investors for holding onto the stock, and the regular income attracts new investors, which serves to drive up the company’s stock price over time.

Choosing dividend-paying stocks

When a company pays dividends, it can be a sign that it has consistent cash flow and expects a steady income stream. It can also indicate a company is financially stable.

Dividends are often held up as a sign of a company’s maturity, because firms that are still in their growth phase generally have to use most, or all, of their cash to fund expansion.

When considering whether to buy a dividend stock, financial advisors say investors should look at a company’s payment track record. Things to look for include:

• Does the company have an established history of offering dividends?
• Have its payments remained stable and increased over time, or has the company occasionally cut its payout?
• What percentage yield does it offer? Is that number realistic or does it seem unsustainable? Experts say a good rule of thumb would be a maximum dividend of 4%
• What’s the payout ratio — or the percentage of its earnings the company returns to shareholders? While a high ratio like 80% may excite investors, experts say such elevated percentages are also cause for caution. Giving away a high percentage of earnings could lead to future dividend cuts. A payout ratio around 50% is more likely to be sustainable. And, if you’re using dividends to replace fixed-income investments like bonds, that’s what you want.

More: What are dividend reinvestment plans?