What Is Dividend Investing and How Does It Work?

A brief introduction to dividend investing for beginners

Dividend Investing Strategy
••• Dividend investing is about one thing: Buying shares of stock that pay large cash dividends so you have money deposited into your bank account or mailed to you regularly. Dividend investors look for stocks in strong companies with high dividend yields. Getty Images

As an investor, you might have experimented with different strategies to produce income from your portfolio. Dividend investing offers the chance to create a stream of income in addition to the growth in your portfolio's market value from asset appreciation. Buying stocks that pay dividends can reward you over time as long as you take care to follow a few guidelines and make intelligent buying choices.

The Basics: Looking for Safety

Good dividend investors tend to look for dividend safety. This is primarily measured by the dividend coverage ratio. If a company earns $100 million and pays out $30 million in dividends, the dividend might be safer than if the company was paying out $90 million in dividends.

In the latter case, if profits fell by 10 percent, there would be no cushion left for management to use. As a very general rule, dividend investors don't like to see more than 60 percent of profits paid out as dividends.

When considering dividend safety, don't find yourself lulled into a false sense of comfort by a low dividend payout ratio. As one famous investor remarked, it doesn't matter how good the numbers look if you're analyzing a single power plant in New Orleans because there is a tremendous geographic risk.

A terrible, low-probability hurricane that hits just right can wipe the whole thing out. Look for companies that have stable income and cash flow. The more stable the money coming in to cover the dividend, the higher the payout ratio can be without causing too much worry.

Focus on High Dividend Yield or High Dividend Growth Rate

Good dividend investors tend to focus on either a high dividend yield approach or a high dividend growth rate strategy. Both serve different roles in different portfolios and have their respective adherents.

A high dividend yield strategy results in large cash income now, often from slow-growing companies that have substantial extra cash flow to fund dividend payments.

An investor with a  strategy that focuses on a high dividend growth rate would buy stock in companies currently pay much lower-than-average dividends but which are growing so quickly, that within five or ten years the absolute dollar amounts collected from the stake are equal to or much higher than what would have been received using the alternative high dividend yield approach.

For example, during Walmart, Inc.'s expansion phase, it traded at such a high price-to-earnings ratio that the dividend yield looked quite small. Yet new stores were opening so rapidly, and the per share dividend amount being increased so quickly as profits climbed ever-higher, that a buy and hold position could have turned you into a dividend millionaire in time.

In rare situations, you can sometimes find companies with both a high current dividend yield and an almost certainly high future dividend growth rate in a strong economy. When situations like this happen, though they are not without risk, they hold the potential for substantial windfalls of future passive income.

Dividend Yield Income Example

If a stock pays a $1 dividend and you can buy shares for $20 each through your stockbroker, the stock has a 5 percent dividend yield because that is the equivalent interest rate you are earning on your money [$1 dividend divided by $20 stock price = .05, or 5 percent]. In this scenario, if you were to invest $1,000,000 into dividend stocks with 5 percent dividend yields, you would receive $50,000 in dividend income

Qualified Dividend Income and Margin Accounts

If you are investing in dividend stocks, look for dividends that are designated as "qualified." If you trade dividend stocks in your search for dividend income you might miss out on a tax benefit. Qualified dividend stocks held for a longer period of time, usually 60 days or longer, get the benefit of lower dividend tax rates. If you buy dividend stocks to get the dividend payment and then want to sell them quickly, you'll have to pay your regular tax rate on the dividend income.

If you invest through a margin account instead of a cash account, it is theoretically possible your broker will take shares of stock you own and lend them to traders who want to short the stock. These traders, who will have sold the stock you held in your account without you knowing it, are responsible for paying you any dividends that you missed since you don't actually hold the stock at the moment.

The money comes out of their account as long as they keep their short position open, and you get a deposit equal to what you would have received in actual dividend income. Since the cash is not actually dividend income, you can't treat it as qualified dividend income. Instead of paying the low dividend tax rate, you'll have to pay your personal income tax rate.

Investors That Prefer Dividend Investing

Conservative investors tend to prefer dividend investing because there is considerable evidence that as a class, dividend stocks do much better over time. Some theories say that a company establishing a dividend policy forces management to be more selective in acquisitions and capital allocation policies, leading to overall better returns.