What Is a Dividend and How Do They Work? Looking for a way to invest in a company? Dividend stocks might be a good place to begin. Read about what a dividend is and how it works.

"Dividend" is a term you may have heard in business or finance. It involves the stock options you can invest in and how that investment can work for you.

If you're looking for ways to combat inflation or want to know more about investment options with dividends, read on to learn about dividends and how they work.

What is a dividend?

Dividends are a type of payment that a company uses to distribute profits to its stockholders. When an investor puts their money into a stock, they earn a total return on their investment through regular dividend payouts.

Dividends are a sign of financial health, as companies that pay dividends have the means to share their financial surplus with investors rather than needing that money to run the business. Companies pay dividends as a way to build trust and credibility amongst shareholders.

Generally, dividends are options offered by well-established companies, not small businesses or startups.

Related: We Are the Champions: 3 Dividend Growers Wall Street Loves

How do they work?

While not all companies offer dividends, it can be an excellent investment for those that do. Dividends are payouts that happen yearly, as they are regularly scheduled payments that a dividend-paying company provides to its shareholders.

The company's board of directors dictates the payout amounts and the payout schedules for dividend income. Payout schedules generally follow a monthly, quarterly or annual schedule. The board also constructs dividend policies for payouts which consider the following:

• Projected growth.
• Income stability.
• Reinvestment opportunities.
• Competitor policies.

Imagine you buy 100 shares of a company at a $5 share price. This puts you at a $500 investment. If each share pays out $0.50, your dividend payments in one year would be $200.

Once you receive your dividend payout, the money is yours. From there, it is up to you what to do with it.

Types of dividends

Companies that offer dividends can do so in several different methods. Look at the types of dividends to know what to look for if your company provides the option.

Stock dividends

Stock dividends are company payouts that are given in the form of additional shares. This means that instead of receiving a cash value, the company pays in more shares of stock.

Dividend reinvestment programs (DRIPs)

An employee who elects a dividend reinvestment program will reinvest dividends payouts into the company. Usually, the company offers employees a discount to promote that investment. Most companies make DRIPs optional and also allow employees to elect cash dividends.

Cash dividends

Cash dividends are likely the most popular type of dividend because they offer the most flexibility. Cash dividends pay out in the form of cash, meaning that when it's payout time, the money is the investor's to withdraw from their account or reinvest.

Special dividends

Special dividends work like bonuses. Bonuses are not a given and are not distributed on a regular, recurring basis — special dividends are the same.

Special dividends generally occur when a company reports larger-than-normal earnings from a strong quarter, large sale or critical event. Companies may issue special dividends at the same time as regular dividends or at a separate time — it is up to their discretion.

Property dividends

Property dividends pay out in property instead of cash, stock or other options. With property dividends, dividend amounts occur in some type of physical asset or real estate.

Related: 3 Top Industrial REITs to Add to Your Dividend Portfolio

Liquidating dividends

Liquidating dividends come into play when a company is closing down or making partial liquidations. In this case, dividends might be paid out as cash dividends or property dividends.

Scrip dividends

Companies who want to give their shareholders options can offer scrip dividends, which can be paid out in cash or stock. This gives employees flexibility, so if a company provides this option, shareholders can analyze each to make the best personal financial decision.

Preferred dividends

Investors who own preferred stock receive preferred dividends at the time of payout. Preferred stocks operate more like a bond, as they are usually a fixed rate instead of a fluctuating amount.

Dividend dates to note

Dividend dates are essential parts of the investment process, as they provide parameters of when investors can sign up and when they'll be paid. These dates are certainly must-knows, as they can make a difference in your return on investment.

The company's board of directors creates the payout schedule and the payout amounts, so be sure to note this before investing to ensure you maximize your opportunity.

Declaration date

The declaration date can also be referred to as the announcement date. On the declaration date, the company's board of directors declares that shareholders will receive dividends.

Before companies announce the declaration date, they often consider factors like retained earnings and past dividends.

Ex-dividend date

Also referred to as the ex-date, an ex-dividend date determines which shareholders are eligible to receive dividends. Shareholders who own stocks by the ex-date can receive dividends when the time comes.

However, shareholders who buy the stock after the ex-date cannot receive the dividend payment. Pay attention to this date, as purchasing a company's shares after the date has passed won't provide you any benefits for that period.

Another factor to note is that if a shareholder owns the stock on the ex-date but decides to sell their shares before the payment date, the shareholder will still receive their dividend.

Record date

A company will set a final date for which a shareholder can be on the books: the record date. This is the last date shareholders can be eligible for the next dividend payout.

Payment date

The payment date is what it sounds like — payday. Shareholders eligible to receive dividends are paid by their company on the payment date.

Related: Monthly Dividend Stocks Can Provide Solid Income

4 factors in evaluating dividends

1. Dividend history

When evaluating whether or not a share investment is suitable for you, it is crucial to look at the company's dividend per share (DPS) history. The DPS shows you the history of the dividend-paying stock.

The key to looking at the DPS is ensuring that the company increases dividends yearly or as regularly as possible. If a company increases its dividends yearly, it shows financial health.

2. Dividend yield

A dividend yield is the company's annual dividend divided by the company's stock price on a given date. A company's dividend stock price and its dividend yield are directly related. When a dividend stock price goes up, the dividend yield decreases and vice versa.

A company's dividend yield may rise if:

• The company raises its dividend.
• The dividend remains unchanged even as the stock price goes down.

A company with a high dividend yield is certainly enticing, but make sure you research its dividend history to see its numbers' consistency.

Related: Why Invest in High Yield Dividend Stocks?

3. Dividend payout ratio

A dividend payout ratio is the number of the company's earnings allocated to its dividend payments. While looking for a lower number might seem strange, avoid investing in companies that offer 100% or more of their profits. Instead, look for payout ratios of 80% or below.

Companies that offer 100% or more of their profits are not sustainable and might be experiencing tough times.

4. Dividend tax rate

Your dividend tax rate will depend on what tax bracket you qualify as — your taxable income and filing status. The qualified tax rate will be 0, 15 or 20 % based on your tax return information.

Related: 2 Dividend Stocks That Can See Your Portfolio Through Tough Times and Beyond

Pros and cons of dividend stocks

Before making any type of investment, it is essential to weigh your options and have a holistic picture of what might be in store.

Pros of dividend stocks

• Predictable payouts: With dividend stocks, payment dates are set. Shareholders know when they will receive their payments instead of wondering if or when it will happen.

• Growth opportunities: Most companies offering dividends are well-established, so they can predict their growth and increase dividends yearly.

• Stability:In general, dividend stocks are a safer option than others. They still mimic stock market movements but have a more stable reaction to market trends than others.

• Tax efficiency:Dividend stocks are taxed at a lower rate than bonds and other income. Depending on your tax bracket, you might not even pay federal income tax on dividends. Even if you are in a higher tax bracket, taxes are controlled and much less than bonds or income.

Cons of dividend stocks

• Lack of control: Dividends are entirely at the discretion of the company. This means that a company can reduce or eliminate dividend payments whenever they see fit.

• Lack of portfolio diversification: Most companies that offer dividend payments are well-established companies in the utility or industrial sector. Other stock options might be a better fit if you are looking to invest in other areas, like tech or real estate.

• Potential risk: Because dividend stocks follow the market, they are subject to market trends. They are not quite as safe as bonds and will go down in a Wall Street bear market.

Related: Stock Dividend Cuts Happen Are You Ready?

What to know about dividends before investing

When it comes to financial decisions, there are so many investment options out there. If your company offers dividends, it can be a fantastic, primarily stable, option to add to your portfolio.

Remember that there are many different kinds of dividends, so when choosing to invest, find one that makes the most sense for your personal finances.

In addition to that, do your research on the dividend history, yield, payout ratio and tax rate before making your final decision.

For information on other financial topics like mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs) and more, check out Entrepreneur.com.