How to Make Passive Income from Stocks
In recent years, passive investing has become a buzz word. In this article, I will talk about passive income. Passive income should not be confused with passive investing. When it comes to investing in stocks, generating a reliable and dependable passive income is anything but passive.
The goal is to structure your portfolio in ways that allows it to meet your goals for both income level and income growth over time.
Before we do this, let’s take a look at how stocks can generate income.
Two Main Source of Income from Stocks – Dividends on Common Shares and Dividends on Preferred Shares
Ultimately, both preferred and common are a type of stock, so it may seem strange to treat the dividends on these differently (see a discussion of the difference between common stock and preferred stock here)
However, this makes sense as Common Stock behaves like an equity stake in the company, whereas Preferred Stock behaves more like a bond in many respect. For example, the coupon on a preferred stock never changes as long as the preferred shares are outstanding. Dividend on a common stock can be raised, lowered or eliminated at the pleasure of the company. When the company misses payment of dividend on a preferred stock, the company is legally obligated to make it up to the investors by paying the missed payment later.
Preferreds are still junior to the bonds and are considered equity. They are senior to the common stock. Dividends on the preferred share will be paid first, before any dividend is paid out on the common shares. Preferreds have a par value, common stocks may be issued with no par value (at least in the US).
For all these reasons, Preferred Stock is safer to invest than Common Stock. The dividend payout is also more reliable. This safety comes at a price though. You will not get any growth in dividends over time with preferred stock. However, if your goal is consistent income, some preferred stocks in your portfolio will add the stability and base income level to your portfolio.
What Should You Look for in a Dividend Paying Stock?
When you invest for income, you should consider the amount of income you will receive for your investment, how secure this dividend payment is, and whether this will grow over time. Additionally, you will also want to consider if your principal that is invested in the stock is likely to grow, or atleast stay even.
Many investors who are in for the very long term, may consider the reliability of a dividend and consistent growth over time as the primary criteria in choosing these investments. If you want a consistent and growing income stream, you should look for these dividend growth stocks.
Some other investors are primarily looking for great values, and they consider dividends as a key signal to show that the management is shareholder friendly and generates sufficient cash flow to support its dividend. If you are one of these investors, dividends for you are a very important signal, but your goal is to make money on the capital gains.
In this article we are looking at generating passive income – therefore we will look at the first case in detail.
To generate a solid and growing passive income from stocks, you need the following:
- Stocks that pay attractive dividends today
- Stocks that have a history of growing dividends and are likely to continue growing their dividend in the future, and,
- Companies that have solid and sustainable business that will last for many years or decades
Let’s look at each of these in detail.
1. Stocks that Pay Attractive Dividends Today
Dividend yield is the ratio of a stock’s annual dividend by its current stock price. If the dividend yield is 5%, it tells you that for every $100 you invest in this stock, you can expect to get $5 back in dividend in the next 1 year.
Logically, higher dividend yield is better. In reality, a very high dividend yield may indicate a distressed stock price and is likely not sustainable. Suppose a business runs into some difficulty and suddenly the future doesn’t look too bright. Investors may sell the stock and drive its price down. The dividend yield now looks very high. However it is likely that if the company is not able to support its level of profits in the future, it may want to reduce or eliminate its dividend to conserve cash.
Generally, a 5% dividend yield is nice, anything much higher than this should require additional scrutiny. Most well run companies will have their dividend yields between 2% and 5%. In today’s environment when the market is getting beaten down, you will find many stocks offering 7%-8% dividend yield or even higher. This yield will likely come down in the future for many.
2. Stocks that have a History of Growing Dividends
Many companies that are well established in their industries and generate ample cash flow reward their shareholders with a dividend increase every year or so. There are compamies that have consistently increased their annual dividend payment for 50 years or more. These companies are committed to continue this in the future and investors can assume that in most cases they will. For a dividend growth investor, these stocks form the bedrock of your portfolio.
Companies that fall into this category are termed Dividend Aristocrats, Dividend Kings, or other similar names depending on how long they have kept up their dividend increases.
Stock screeners such as Stock Rover give you the information about the history of dividend growth.
3. Companies that have Solid and Sustainable Business
Finally, you want to make sure that the company you buy stock in will be around in 10-30 years time. This way you receive the benefit of regular and possibly increasing dividend income without worrying about losing invested capital or dividend cuts in the future.
This is hard to predict and the best you can do is to look into the company fundamentals and determine if they are strong. If you find that the company has some sustainable competitive advantage, it is very likely that they will continue to enjoy the current market share. You also want to make sure that their business itself does not disappear in the future. For example, the demand for diapers will be there 50 years from now. I cannot say the same about the demand for iPhones.
How Should You Construct Your Passive Income Dividend Growth Portfolio?
Compound interest. If you know how it works, you are way ahead of the game. In a dividend growth portfolio, the compounding occurs when you reinvest the income you receive back in the dividend stocks (so it will now generate more income in the future). If you keep reinvesting, eventually the compounding takes on a life of its own and your portfolio will grow rapidly.
Most brokerages now give you the opportunity to auto-reinvest dividends in the same stock. Alternatively, you can let the dividends collect in the portfolio and then manually reinvest it in additional shares. This is now easier to do as most trading is now commission free in the US. If you are still paying commissions, check with your broker about dividend reinvestment plans – thy tend to be commission free.
You should also have a portfolio of atleast 10-15 stocks to diversify some of the risk away. Since most companies in the US pay dividends quarterly, having many stocks will also allow you to spread out the dividend income more evenly throughout the year. There are some stocks that pay dividends monthly as well and these could be part of your consideration.
If you want an example of well designed dividend growth portfolio, you can find one at Value Stock Guide.