Dividend investing is a popular strategy to create an additional income stream for many people. Is it simple? Sure. But can you make a living from dividends?
If you’ve spent even a minute on the internet looking for ways to make money online, you’ve probably been bombarded with messages of making money online through passive dividend investing.
What is Dividend Investing
Dividend Investing means that you invest in stocks specifically of companies that pay dividends either monthly, quarterly or annually.
This results in additional income to you (the investor) in the form of dividends.
Investing in stock with dividend income can be viewed as a less risky form of investing.
Create cash flow
This is probably the biggest reason even to consider dividend investing. If you have any money, investing in dividend stocks can be a simple way to create an additional income stream without a lot of effort.
It is truly a passive investment because once you purchase the stock, you do nothing! Just watch the dividends being in your bank account!
Reduce investment risk – realize some gains
Let’s say you invested in stock at $5 in a company that you thought would do exceptionally well for the foreseeable future. The stock does well and is one year later valued at $10. You now have a 100% return on paper, but since you did not cash in the growth, the gains are unrealized (i.e., they’re not in cash). Now, imagine that you decide to keep that stock, and 3 years later, the company goes bankrupt. You have lost not only your 100% return but your initial investment of $5. You are now down $5!
Instead, let’s say you invested in this stock, which also cost you $5, but it pays a $1 dividend every year. This stock also grows and is valued at $10, and just like the scenario above, you keep the stock. You would have $5 in unrealized gains and $1 from the dividend. Now, imagine that this company also goes bankrupt 3 years later. You would lose $5 of initial investment, any unrealized gains, BUT you would have received your $3 in dividends ($1 for each year you held the stock). In this case, you would have lost in total $2 (since you recovered $3 in dividends).
Investing in stock with dividends allows you to realize SOME of these gains beforehand.
What kind of companies pay dividends?
Now you’re probably wondering, why would a company give you the cash?
When a company makes a profit, they have two choices: 1) pay it to their investors, or 2) retain the profit for future growth.
For many companies, paying dividends is a way to reward their investors, i.e., saying thank you for investing in us – we had some leftovers!
Another way to look at it could be that the company is saying we don’t have anything better to do with the money, take some of your investment back! Looking at the payout ratio (we’ll get into this later) can be an excellent way to judge whether this is good or bad for the company.
Once a company starts paying dividends, investors often expect these dividends to be paid out periodically. This is why you’ll typically see dividends being paid out of companies that are older, more mature companies, where they can reliably forecast their cash flow.
They come in all industries. A good list to look at is the dividend aristocrat list. These are companies that have paid increasing dividends for the last 25 years.
How to start dividend investing?
There are straightforward ways to invest in dividends.
One: Individual stocks
This is a more active form of investing.
- Find dividend paying stocks – starting with this list of Dividend Aristocrats can be useful.
- Evaluate the company – pay attention to the current and historic yield, payout ratio, dividend growth rate.
- Decide how many shares you want to buy or how much you want to invest.
Two: Dividend ETFs
Dividend ETFs are a low effort way to invest in dividends. It is an easy way to diversify your money across many dividend-paying companies.
- Find dividend paying ETFs
- Analyze the ETF – pay attention to the dividend yield, growth rate, and expense ratio.
- Decide how much you want to invest in the ETF
Some ideas to start your search are: Vanguard Dividend Appreciation ETF (VIG) or iShares Core High Dividend ETF (HDV).
Note: This is not investment advice, just some ideas to start your search for dividend investing.
What’s the best way to invest in dividend stock?
The answer to this will depend on you, the investor.
Investing in a dividend stock might be more active, as you really have to scrutinize the company. But on the other hand, you have more control.
Investing in a dividend fund can help you diversify your investment. You don’t have control over what specific companies you are invested in, but you are not exposed to the risk of just one.
How to find good dividend investments?
If you decide to pick the individual stock route, you do have to do more work. It’s less passive than investing in a dividend fund!
You are buying a slice of the company you are investing in. No matter how small that slice is, as an investor, you have to do your due diligence!
Think about it, as purchasing a small business. To get you started, here are some ratios you should consider when looking at investing in dividend-paying stocks.
Dividend Yield
This is a very simple calculation. But a very important one.
Dividend Yield = Dividends paid / Price of stock
If a company pays $1 annually and is trading at $20, then your yield is 5%.
You could then compare this against other dividend-paying stocks, but also against other investments you could make, versus the risk that they come with. Let’s say you find a stock that pays you a 1.5% dividend, but your bank pays you 1% on your savings account. You might want to consider whether investing in a dividend-paying stock is worth the risk now.
Should I just look for stocks with a high dividend yield?
Unfortunately, it’s not that simple. This can also be a very risky move!
Say you find a stock that pays a 30% yield. That should raise red flags for you. It’s too good to be true!
The dividend yield could be higher because the stock price has been decreasing, making the return seem way more attractive than it should be! You would have to decide if the stock is on sale or if the lower price in the market is a reflection of its future potential.
Dividend Growth
Has this company been paying out dividends consistently? Has it grown over the last few years? Or has the amount been all over the place?
There is no guarantee of dividends, but the company’s history in paying dividends can give you a sense of how much you can expect in dividend payments.
Dividend History
Has the company been paying dividends on a schedule – monthly or quarterly? Or has it missed many dividend payments?
There is no guarantee of dividends, but the company’s history in paying dividends can give you a sense of how reliable their dividend payment might be.
Payout ratio
Payout Ratio = Dividend paid / Earnings per share.
There are many variations of this ratio, so try not to get lost in the numbers, but rather pay attention to what it tells you!
The payout ratio indicates how much a company is paying out to you as an investor. This ratio can range from 0% to over 100%.
Theoretically, what a company is not paying out in dividends can be reinvested back into the business to continue growing the business. This, for you, as an investor (owner), is good! As long as you think the company will continue to make good decisions, then you should be happy they’re using their earnings to put back into the business and keep growing!
It’s hard to pinpoint the optimal number or range, but here is a simple guide:
- Under 30%: considered low, BUT they might be growing the business and using cash for those projects rather than paying them back to investors.
- 30% to 50%: considered to be a healthy range
- Over 100%: this could be a red flag, because it means that they are paying out in dividends beyond what earned in that period! Maybe via debt, maybe by eating through cash reserves. Either way, this would warrant more scrutiny. There is a good chance this is not a level of dividend you can continue expecting!
Dividend Investing: there’s no guarantee
Dividends are not guaranteed. Sure, dividend investments can be considered lower risk relative to the stock market, but they are not guaranteed. Dividends are still risky!
Companies may find new opportunities
Dividends are essentially money left over after a company has kept some of its profits to grow. Sometimes, there may be an opportunity for a company to buy another company or create a new line of business, for which they need to retain more of their profit. They could, in theory, decide not to declare a dividend to shareholders in these cases.
Of course, as an investor, you should not be disappointed. This could be good for you if the company is making good decisions!
They may have a bad quarter / year
The company you invested in may have a slowdown in business or a one-time crisis. They may not have the cash to pay out dividends to their shareholders after all their other expenses. It happens!
Dividend Investing Considerations
If you decide to invest in dividend stocks, you need to also think about your overall financial picture.
Dividends & Tax
As an accountant, the first thing I would put on this list is, of course, tax. Depending on the tax laws in your area and other income sources, the income from dividends can impact your tax situation.
It’s best to ask your accountant if you’re concerned about tax.
Dividends & Growth
What will you do with the dividends?
If you’re relatively young and don’t need the cash flow from dividends, will you put them back in another form of investment?
Dividends & Your Finances
Don’t do it because everyone else is doing it. You should consider if dividend investing is right for your investment portfolio and if it fits with your money goals!
Can you really live off dividends?
Now, here’s the BIG question!
Most people who talk about making money online will include dividends as a great way to make extra money!
And it is! You do nothing after you buy the stock to make money.
But, this is one of those ways that you need to have money to make money!
How much do you need to make a $100 per month?
Assuming an average 3% dividend yield, to make an extra $1,200 per year, you would need a portfolio of $40,000 invested in dividend-paying stocks.
So, the short answer is, yes, if you have a lot of money, you could make money!
Dividends can be a great way to supplement your income.
But unless you have a big bag of cash, it is unlikely that you can quit your job relying just on dividend investing!
Dividends and Your Portfolio
Dividends can be an excellent way to diversify your income and create a new income stream for you.
It takes time to build enough capital to create meaningful income, but it’s best to get started sooner than later!
Are you considering creating a dividend investing portfolio?