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Dividends, the Passive Income secret

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What are Dividends?

Dividends are payments made by a company to the owners of their stock. Essentially, it’s a way for companies to distribute revenue back to investors. 

These payments are on top of any rise or decline in the value of the stock.

Companies usually pay dividends quarterly, but some pay monthly or semi-annually. A dividend is paid per share of stock — if you own 40 shares in a company and that company pays $2 in annual dividends, you will receive $80 per year.

Dividends may be issued as cash (most likely) or additional stocks (very unlikely) and may be fixed or variable.

Fixed dividends mean the percentage or dollar amount is the same each time dividends are issued, regardless of the company’s performance.

Variable dividends are tied to a company’s performance, meaning that dividend payments will be higher when a company has done well and lower when it hasn’t. 

Companies can change their dividend policies at any time, even stopping dividends permanently or temporarily.

One thing to remember – not all stocks pay dividends.

Dividend Stocks vs. Growth Stocks

This always creates an argument for investors. Companies that pay out a dividend, are paying shareholders from earnings instead of reinvesting that money into the company like growth stocks. 

Why not get the best of both?

Companies that pay a dividend have historically outperformed companies that don’t offer a regular payout over the long run.

That’s because dividend-paying companies have time-tested business models, and they wouldn’t be sharing a percentage of their profits with their shareholders if they didn’t foresee continued growth and profitability.

Warren Buffett, the legend himself, is a huge fan of companies that offer a dividend. He transformed his roughly $10,000 seed investment into $81 billion. That’s a compound annual return rate of 28% since the mid-1950s, whereas the stock market has returned an average of 7% per year.

Of the 48 securities within Berkshire Hathaway’s holdings, 34 companies pay a regular dividend. In 2019, Buffett’s Berkshire Hathaway will receive $4,646,737,673 in dividends.

Yes, that is over $4 BILLION!

How do stock dividends work?

A company’s board of directors must approve each dividend. The company will then announce when the dividend will be paid, the amount of the dividend, and the ex-dividend date.

The ex-dividend date is extremely important to investors! 

Investors must own the stock by that date to receive the dividend. Investors who purchase the stock after the ex-dividend date, will not be eligible to receive the dividend. Investors who sell the stock after the ex-dividend date are still entitled to receive the dividend because they owned the shares as of the ex-dividend date.

Ever heard of the Dividend Aristocrats?

These are companies within the Standard and Poors (S&P 500) that have increased their dividend payouts for 25 consecutive years or more. Also, these companies have outperformed the S&P 500 index with lower volatility.

Investors who don’t want to research and pick individual dividend stocks to invest in, might be interested in dividend exchange-traded funds (ETFs). These funds hold many dividend stocks within one investment and distribute dividends to investors from those holdings.

What is the dividend yield?

The dividend yield evens the playing field and allows for a more accurate comparison of dividend stocks.

A $10 stock paying $0.10 quarterly ($0.40 per share annually) has the same yield as a $100 stock paying $1 quarterly ($4 annually). The yield is 4% in both cases.

From the picture above, Coca-Cola (KO) has a forward dividend of $1.60 which equates to a yield of 3.26%. So for every 1 stock held of Coca-Cola, you will be paid $1.60 ANNUALLY

I say annually because they distribute that dividend quarterly (split – 4x a year), so $1.60/4 = $0.40 every 3 months. This is why the ex-dividend date is June 13, 2019, because they just paid $0.40 on March 14, 2019.

Does that make sense?

I hope it does! 

Little More Yield 

Yield and stock price are inversely related: When one goes up, the other goes down. So, there are two ways for a stock’s dividend yield to go up:

  • The company could raise its dividend. A $100 stock with a $4 dividend might see a 10% increase in its dividend, raising the annual payout to $4.40 per share. If the stock price doesn’t change, the yield becomes 4.4%.
  • The stock price could go down while the dividend remains unchanged. That $100 stock with a $4 dividend might decline to $90 per share. With that same $4 dividend, the yield would become just over 4.4%.

For most stocks, anything above a 7% yield should be carefully analyzed, as it could indicate the dividend payout is unsustainable.

However, there are some exceptions to this 7% rule — specifically, stock sectors that were created to pay dividends, including real estate investment trusts. It’s not unusual for REITs to pay safe yields in the 6% to 12% range and still have growth potential.

One of the quickest ways to measure a dividend’s safety is to check its payout ratio, or the portion of its net income that goes toward dividend payments.

If a company pays out 100% or more of its income, the dividend could be in trouble. During tougher times, earnings might dip too low to cover dividends. Investors usually look for payout ratios that are 80% or below.

The stock’s dividend yield and payout ratio will be listed on various stock market websites.

The Passive Income Secret

Dividend investing is one of the only true forms of passive income investing I’ve seen in more than 12 years as an investor.

I’ve owned a commercial and home cleaning business, rented real estate and mined cryptocurrency.

More recently, I’ve seen the income potential in blogging, and online stores through the few websites I own.

Dividend Reinvesting has them all beat – for truly passive income.

Dividend Reinvestment 

Reinvesting your dividends simply means purchasing additional shares of stock with the money you receive. On some trading platforms, like M1 Finance (my personal favorite!) you can have this done automatically by simply checking a box.

Ok, so what’s the big deal?

By reinvesting your dividends to purchase new shares of a stock, you can grow your investment at a quicker rate. You can pocket the cash – but you rely solely on capital gains to generate wealth – which provides NO tax advantages!

The benefit of dividend reinvestment is its ability to grow your wealth quietly. As in set-it-and-forget-it investing. Later in life when you need to supplement your income, usually after retirement, you already have a stable stream of investment revenue – passive income – at the ready.

“Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.”

-Warren Buffett

Dividend Reinvestment Growth Example

Let’s do some public math!

Assume the stock YOLO pays an annual dividend of 3% per share, and its stock price increases by 10% each year. If you invest $10,000 when the stock price is $25, you own 400 shares (I didn’t include brokerage fees because I am assuming you’re using M1 Finance). 

At the end of the first year, you receive a dividend payment of 3% which amounts to a payment of $330.

Uhhh? 3% of $10,000 is not $330!

I know, remember each year we assume the stock goes up 10% – so the stock is now worth $11,000.

By the end of Year 1 – the stock price increased to $26.68, so your reinvested dividend purchases about 12 additional shares. 

At the end of the second year, you earn the 3% dividend on all 412 shares, yielding a total payment of $363. The stock price rises to $28.46, so reinvesting this dividend buys another 12.8 shares.

You now own 425.12 shares valued at $12,100

Three years after your initial investment, you receive a dividend of 3% x $13,310, or $423.62. Since the stock price has risen to $30.37, your dividend purchases another 13.2 shares. 

At the end of three years of reinvesting your dividends, your investment has grown from 400 to 438.3 shares. In addition, due to the stock’s capital gains, the value of your investment has grown from $10,000 to $13,310.00.

Because your reinvestment is automatic, you have not paid any commissions or transaction fees for the privilege of growing your investment. Nor, have you injected additional cash.

The Aftermath

If YOLO’s stock performs consistently and you continue reinvesting your dividends for another 17 years – equating to a 20-year holding period. You will own 735.6 shares valued at $67,275.

Remember, after the initial $10,000 you invested – you did not add any additional contributions.

If you have stopped working, you may choose to start taking your cash dividends to supplement your retirement income. Your 3% dividend is now worth $2,018.25 and will continue to increase as the value of your stock goes up. 

If you had pocketed your dividend payments instead of reinvesting them, your original 400 shares would be worth $36,583.76, plus $13,093.50 in dividends, for a total of $49,677.26.

By simply reinvesting your dividends each year, you increased your gains by 135%!

Conclusion

As I stated, dividend investing is one of the only true forms of passive income investing. Once you make an initial contribution, you can literally set-it-and-forget-it. If you use M1 Finance, you can auto-reinvest all your dividends – for FREE.

To me, that is passive income because I literally do nothing as my money grows. 

Long story short, dividends have been a major contributing factor to Warren Buffett’s success – they can be for you too.

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