Passive income is the best income. I frequently argue this case to the readers of my personal finance blog. Passive income is money that comes my way based upon work that I’ve done in the past. It might come from an article or a blog post that I wrote years ago, or it might come from a dividend-paying stock that I bought a couple of months ago. It comes in whether I decide to work hard on a given day or I choose to sleep in and watch a football game. Most people think that more work is required for additional income, but passive income requires no additional effort on my part. This is why I think passive income is the best type of income to have and I want to build it up over time. When thinking of passive income and how to increase it, I’ve decided that dividend income is the best passive income. Here are four reasons why I’ve come to this conclusion.
1. Dividends Are A Solid Component Of Return On Capital
When many people think of investing in stocks, they don’t really have investing in mind. They tend to picture greedy men in suits running around on Wall Street or day traders sitting in their living room who try to make quick trades to cash in capital gains. This is trading in the best-case scenario and speculating at worst. People who are actual investors find a company that they like that has solid revenue and income streams. They generally intend to hold a stock for the long run. Warren Buffett, possibly the greatest investor ever, argues that his ideal holding period is forever. Investors understand that the stock of a company they choose might go up $2 one day and down $4 the next. In a recession, most stocks will get hit. This does not mean that the underlying fundamentals of a given company are necessarily bad. It could just mean that stocks are on sale.
Many companies that make a nice level of income over time decide to pay a portion of their profits back to investors in the form of a dividend. This is actual cash that can be used in any way a shareholder might decide, and depending upon the amount of the dividend and any growth in that dividend over time, an investor could actually see all of their original capital returned to them, and then some. This all happens while the investor continues to own a portion of the company. If the company has the growing revenue and income over time that is necessary to support a growing dividend, it’s also likely that the price of the stock will appreciate. This is a win-win situation for the shareholder.
2. Dividends Can Usually Be Reinvested Easily
There are basically two ways that an investor who decides to reinvest dividends can do so. The first option is to sign up for a dividend reinvestment program, otherwise known as a DRIP. A DRIP buys additional shares in the company that paid out the dividend. For example, a hypothetical company might have a share price of $100 and a quarterly dividend payment of $1. For every 100 shares that an investor holds, he or she would get one additional share the first quarter. An investor with 50 shares would receive one-half of a share. This process is usually available for those who buy shares directly from a company, but it is also available through many brokerages. Charles Schwab, Fidelity, and TradeKing are just three of the online discount brokerages that allow for DRIPs. All that the investor has to do to DRIP is inform the company or brokerage that they want to. There might be a request form, but it’s usually a pretty painless process.
The second option for those who want to reinvest their dividends is to collect dividends from all companies that they own and then make a purchase when the pool of dividend payments gets to a certain pre-determined level, be it $500, $5,000, or anything in between. They could also choose to jump on a great company at a great price if the opportunity arises before reaching the ideal amount of pooled dividends. This reinvestment can go toward a company that the investor already owns, or it can go toward diversifying into a new company. Regardless, it is a deployment of new capital that can bring more passive income over time. In the interest of full disclosure, I’ve used both of these methods for reinvestment at different times. I’m currently pooling my dividends, rather than allowing them to automatically reinvest into the company that paid them, but I am not fundamentally opposed to DRIPs.
3. Dividends From The Right Companies Can Grow Over Time
There are several publicly traded companies that have grown their dividends for 25 years or longer. Even better, there are a few that have a dividend growth record of at least 50 years. Both Johnson & Johnson and Coca-Cola have grown their dividends every year since the Kennedy administration. Getting a dividend increase each year is essentially getting a raise on your passive income that will oftentimes exceed the amount of any raises your regular employer will give you. When trying to find a solid dividend growth company, it’s a good idea to look at metrics like income growth, revenue growth, and dividend payout ratio (the percentage of profit that’s paid out to investors). Growing income and revenue are good signs. A relatively low dividend payout ratio is a good sign, as well. I’ve seen investors who want a ratio of below 50 percent. Others are comfortable with a payout ratio of 80 percent. Regardless, lower payout ratios are generally better.
4. The Combination Of Reinvestment And Dividend Growth Can Lead To A Compounding Stream Of Passive Income.
Putting dividend growth and reinvestment together can lead to a supercharging of your passive income stream. Reinvesting a dividend effectively increases your dividend payment by the current yield. For example, if the current yield is 4 percent, an investor who initially had 100 shares would have slightly more than 104 shares after a year (because of compounding), and the dividend payment for the next year would be more than 4 percent higher (and growing because of compounding). After two years, she would have more than 108 shares, and so on. This example assumes a stable dividend and share price. Dividend income would double in about 18 years in this scenario based upon the rule of 72.
When the dividend grows, however, the passive income stream would increase even more rapidly. With the example given above, the dividend yield and the rate of the dividend increase would get added together to calculate the overall increase in dividend income on a year-over-year basis. The 4 percent dividend yield, if combined with a 6 percent increase, would effectively lead to a more than 10 percent increase over the course of a year (keep in mind that compounding is in play every time a dividend gets reinvested). If this process could continue for about 10 years, based upon the rule of 72, our hypothetical investor would see his income grow from $100 to roughly $200. This all happens with no new investments outside of reinvested dividends, which is why I believe dividend income is the best passive income.
Caveats and Concerns
While I firmly believe that dividend income investing is a great way to build wealth over time, investors should perform due diligence when putting available capital toward equities. Dividend cuts definitely happen, and from time to time dividends are suspended altogether. Companies can also go belly up. These are all risks that come with investment although diversifying across companies that have solid financials and reasonable payout ratios can limit the possible risk and make it more likely that a dividend investor can succeed over the long term.
This article is intended for educational and informational purposes and is not intended as a recommendation to purchase any particular investment. Be sure to perform due diligence before putting money toward any investment.