There’s no such thing as free lunch, but there is such a thing as free money. Well, kind of.

Investors in dividend stocks earn money just for owning company equity. However, it’s not always smart to invest in stocks with the highest dividends. Read on to learn more about dividends and how to consider them in your investment portfolio.

What are dividends?

Dividends are payments made to stockholders by the company that issued the stock. The payments are distributed quarterly (or sometimes yearly or monthly) according to how many stocks each shareholder owns.

Not all stocks earn dividends, but that’s not necessarily a bad thing. There are several circumstances that stockholders must be wary of when it comes to dividends. Here are some basic guidelines to note if you want to maximize the value of your investment portfolio with dividend stocks.

How do dividend payments work?

In order to understand dividend payments, it's important to first understand how stocks work. A stock is a partial share in a company, meaning that stockholders have equity in, or own part of the company.

There are two types of stock: common stock and preferred stock. Preferred stock dividend payments are cut and dry; they are fixed payments made on a set schedule, similar to corporate bonds. Common stock (which is the more common type of stock) has many other factors that play into how dividend payments work.

Why do companies pay dividends?

Dividends can make a company’s stock more appealing to investors. Stockholders receive a steady income of dividend payments, which builds their trust in the company’s stability. If a company is stable enough to pay dividends on its stock, that is generally a good sign that investing in it is a stable choice.

This is not to say that it’s bad to invest in stocks that do not earn dividends. Dividend money comes out of a company’s profits or reserves, so younger companies are more likely to favor growth rather than dividend payments as an allocation for that money. The company’s growth will have a positive influence on the stock’s appreciation, so stockholders have a motivation to buy stock in the company even if there are no dividends that come with it.

Who decides to pay dividends?

Even if stocks don’t earn dividends right away, there’s a chance that could change. The company board decides when to start making dividend payments and decides on an ex-dividend date, or ex-date. On this date, stockholders receive their dividend payments.

Because common stockholders have voting rights, they have a say in the decision of whether or not to pay dividends. Stockholders can vote to elect board members based on how many shares they own, and the board members in turn can determine if and when dividend payments begin, how much they are, and how often they are paid.

Can dividend payments change?

Yes, dividend payments can change, but there are implications that come along with a change in amount. If a company has been regularly paying dividends and then eliminates or cuts them, it could mean their finances are struggling, and the stock itself will go down in value. Buying dividend stock is not a guarantee that the payments will keep coming for all eternity, but keeping an eye on certain ratios can help you guarantee that your dividend stocks are profitable investments. Read on to learn more.

Which dividend stocks should you invest in?

Dividend stocks are popular amongst retirees, who enjoy the regular payments they receive just for owning a stock. However, dividend stocks aren’t for everybody. If you are more concerned about investing in a stock that will appreciate and be worth more when you sell it, you might want to invest your money in a non-dividend stock. Dividend payments are also taxed, unlike stock appreciation.

An evergreen piece of advice when it comes to investing is to diversify your portfolio. Having different kinds of stocks in your portfolio will make your investments more secure overall. Your eggs certainly shouldn’t be in one basket, but it’s also important to check whether you’ve got rotten eggs, or which ones might be fresher than others. The two most important formulas that can help you decide if it’s worth it to invest in a particular dividend stock are payout ratio and dividend yield.

Payout ratio

Payout ratio tells you how much of a company’s net income is being used to pay dividends. This ratio can tell you which stocks’ dividend payments you can rely on and which stocks might be poised to lose their value, even if the dividend payments themselves are currently high.

Essentially, this ratio tells you how sustainable a company’s dividend payments are. A healthy dividend payout ratio varies by industry, but generally if a company’s payout ratio is more than one, it’s a bad sign—the company is spending too much money on paying dividends and not enough on its own operations and investments.

Dividend yield

Dividend yield is the amount of dividends a stock earns in a year represented by a percentage of the stock’s current share price. A higher dividend yield means more money for stockholders in the short term, but it also could mean a riskier investment. A healthy dividend yield varies by industry, but generally hovers between 1-5%.

Payout ratio and dividend yield example

As an example, let’s compare stock from Home Depot and Lowe’s, because it doesn’t get much more comparable than that! They are both in the same industry and are similar companies, so we can hold them to the same standards. Stock in Lowe’s has seen a recent rise in popularity, so let’s find out if it really lives up to the hype.

Because they are publicly traded, we can access both Home Depot and Lowe’s income statements and stock information on the internet. This information can sometimes be found on the company’s website or can be obtained through a stock broker, but it’s usually easier to look at a stock exchange website like Nasdaq. Here is all the information we need to calculate Home Depot and Lowe’s payout ratio and dividend yield as of April 2019.

Courtesy of Nasdaq

Using the ratios above, here’s how to calculate the dividend payout ratio (DPR) and dividend yield of Home Depot and Lowe’s.

Home Depot

DPR = $5,998,911,040/11,121,000,000 = 0.54

Dividend yield = $5.44/$199.27 = 0.0273 or 2.73%

Lowe’s

DPR = $1,528,172,160/2,314,000,000 = 0.66

Dividend yield = $1.92/$112.73 = 0.0170 or 1.70%

Courtesy of Dividend.com

What do these calculations tell us?

Based on these results, either Home Depot or Lowe’s stock would be a decent investment, however stock in Home Depot may be a cut above. Even though Home Depot’s dividend payments are higher, with a lower DPR at 0.54, the company is proportionally using less of its income on dividend payments than Lowe’s, whose DPR is a little higher at 0.66. Lowe’s might be okay for now, but investors should keep an eye on this ratio to make sure the company isn’t spending too much on dividend payments.

As for dividend yield, Home Depot’s is higher, meaning that their investors are making more dividends relative to share price. At 2.73% vs. Lowe’s at 1.70%, Home Depot’s stocks are more worthwhile investments for those wanting to earn dividends.

This isn’t to say that there’s no reason to invest in Lowe’s—the shares are less expensive and still have potential to appreciate over time, but in the short term, Home Depot’s stocks will earn more dividends.

Free lunch money and more

Now that you’ve learned what dividends are and how to be smart about investing in dividend stocks, it’s time to purchase some shares and watch the dividends pile up. After some time you might find that you’ve earned more than just lunch money. 

What is a stock in the first place? What's the difference between common and preferred stock? Find out more on the Learning Hub.