Tuesday, September 21, 2010

My take on dividend investing for passive income

I’m a huge believer in a portfolio of good dividend paying stocks as a great source of passive income. In this article, I will give you my take on how investors can build a portfolio of dividend paying stocks that can generate for them healthy passive income.

Dividend yield
The dividend yield is the amount of money a company pays out per share as dividends, expressed as a percentage of its share price. So, if you bought a stock with a 5% dividend yield, and assuming that there are no dividend cuts and etc, you can expect pre-tax dividend income of 5% of your initial investment.

The higher the dividend yield when you bought the stock, the higher your passive income. But investors should, however, beware of stocks with high dividend yields, and conduct proper research on the stock to see if the dividend is sustainable.

Free cash flow
 A lot of people look at the dividend payout ratio (the percentage of profit a company pays out as dividends) as a way to analyze the safety of the dividend. While I have nothing against the dividend payout ratio, I think that for the purpose of deciding whether or not a company’s dividend is safe, that investors should instead look at the percentage of free cash flow the company pays out as dividends.

By measuring the dividends a company pays out against its free cash flow (cash from operating activities - capital expenditure), investors can have a better picture of the safety of the dividend as free cash flow takes into account expenditure needed for future growth, so investors can worry less about the company suddenly cutting its dividend to fund its growth. Net income can also be more easily manipulated than cash flow, which can affect the soundness of using the dividend payout ratio to gauge the safety of a company’s dividend.

Generally, the lower the percentage of free cash flow used to pay out dividends, the safer the dividend.

Profit and revenue growth

From a dividend income standpoint, we want the companies we invest in to regularly raise their dividend. And the only way a company can keep raising its dividend in the long-term is for it to have long-term profit and revenue growth. That’s why I believe that investors should invest in dividend paying stocks that are still growing their revenue and income at a decent rate.

Dividend history
Investors should look for companies that have a history of raising its dividend. This shows that the company is willing to give back the wealth to its shareholders. Nothing is for certain, but if the company is still growing profit and revenue, and it has a history of raising its dividend, it won’t be unreasonable to expect that the company may increase its dividend again sooner or later.

Size doesn’t matter
I personally don’t really pay attention to the market cap of a stock, but only look at the financial condition and performance of a company to evaluate if a stock would be a good dividend income generator long-term. In fact, I generally prefer smaller faster growing companies to big cap companies as dividend income generators, as these smaller stocks have more room to grow revenue and profits, which can in turn lead to more growth in their dividend. But for conservative investors, it might be safer to invest in blue chips.

Don’t get dividend tunnel vision
Investors shouldn’t only pay attention to whether or not a company has raised its dividend, but also take into account other things. Things like share buybacks and strategic acquisitions can also create value for a company’s shareholders.

Reinvest your dividends
Albert Einstein once said, “The most powerful force in the universe is compound interest.” Investors that do not need the income from their dividend income stock portfolio, should just reinvest their dividends and let their stock portfolio compound over time, as this can lead to a huge difference in the value of their portfolio and the passive income it generates over the long-term.

Value dividend paying stocks like you would any other stock
At the end of the day, whether or not a stock pays a dividend, it’s still a stock (I know, I’m being captain obvious here), and apart from also looking at certain things like the dividend yield and etc, we should value dividend paying stocks the same way we value any other stock. You can check out some of the things I look at when evaluating the investment appeal of stocks here.

If you have any questions, or would like to share anything, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

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