When I started considering dividends from stocks as a potential passive income source, I started pondering upon the question; how much dividend income I would need. It is relatively easy to find out the fixed and valuable expenses I have per month. I can multiply that amount by 12, and I will determine how much money I would need every year. That will give me an idea about how much annual income from the dividend is required.
So, How to calculate annual income from the dividend?
- Go to any financial website and open the details for the stock
- Find out how much dividend it pays per stock per year.
- Open Yahoo Finance portal
- Search the stock with symbol or name in the search bar
- Select the correct stock and check the “Forward Dividend & Yield”
- This field gives you a dividend per share amount and the dividend yield for current market price or CMP
- Now that you know the dividend per share, you need to multiply that amount with quality of share to find out the total dividend amount that you will receive per year.
You have purchased 250 shares costing you $60 each. Your total investment is $15000. IF you are making a 5% yield on that, which means every year, you will get a check worth $750, which is not bad. It beats ten years treasury and CDs.
If you buy the same amount of stock for $30, your dividend yield would be %10, and if you buy the same stocks for $120, your dividend yield would be 2.5%.
If the dividend amount is not reduced, then what price you pay for the stock significantly impacts the dividend yield you can earn. And the stock price goes up or down due to sentiment all the time; you need to control your emotions and pay the right price for the stock.
Is the annual income from the dividend guaranteed?
That is not so easy to answer. IF you buy a US treasury or Indian Government bond (rupee bond), you can count on getting coupon payment in USD and INR. That coupon payment might not buy you much. In case inflation makes the currencies worthless. But these are risk-free returns because you are sure to get a return.
Dividend from stock is anything but certain. Although large companies with a lot of free cash flow that do not have many growth plans usually pay a dividend. But, the company might decide to fund capital expenditure to grow or an acquisition. Even a buyback with the retained earnings, in that case, we might not get the dividend. As minority shareholders, we depend on management to decide what they want to do with the retained earnings.
In the worst-case, sometimes companies keep on paying a dividend to showcase that their financials are strong. But during an economic downturn or liquidity/ cash crunch, they fail to pay a dividend. You can google what GM did during 2008-2009. Eventually, they filed for bankruptcy. Before that, they were taking debt to pay a dividend, which was a poor choice. Remember, as a stock owner, you are a part-owner of the business. As a part-owner, you would like to see your business thrive for a long time to come. As it continues to make a profit, you will earn a dividend.
What sectors in the market usually pay good dividend yield?
Oil and gas mining companies pay good dividend yields too. But these are heavily cyclical industries. Last ten years, oil and gas did not generate any return. But you can allocate some part in these sectors to generate dividend income. The best time to invest in these stocks is when economies are in a recession, and these stocks are at the bottom. As their earnings go up and down with the commodity price they produce, the stock price reflects the same cycle.
I am not saying there is no ideal income stock. I am sure there is something out there that would suit you. And I am making you aware of what mistakes you might make. If you buy commodity stocks when the cycle is at the pick, you will face notional loss when the commodity cycle slows down.
If you are not good at picking or analyzing stocks, you can take a basket approach. You can buy a sectorial ETF.When these sectors fall, usually all stocks go down in price. As earning outlook falls, stocks get derated,
and institutional investors reduce their holdings.
In the USA, these ETFs usually pay dividends too. The dividend yield might be less than some stocks in the ETF; the reason would be, some matured stocks have more tips than smaller companies, and as it is a basket approach, the overall dividend yield comes down.
Why chasing the yield might be a wrong idea?
Before you buy any stock for dividend income, you need to do your homework. Unfortunately enough, investing is simple but not easy. So going to screener sites is filtering with dividend yields will most probably cost you money.
For example,say you buy 1000 stocks of XYZ Company for $10 each. That stock is yielding 10%. And anything above 4 – 6% should raise a flag. You should ask, why did the price of the stock fall so much? Analysts are not stupid to sell off an outstanding inventory
Maybe the company has too much debt and too little free cash flow to service the debt. Perhaps that is why analysts think in the future, the company will have to cut its dividend. Or the company earnings are not stable and coming down, so the price dropped in anticipation of earning per share drop. Worse among all corporate governance issues or mismanagement. The company might get into trouble, and that is why the stock price dropped.
What are the things you need to consider before buying an income stock?
Either way, as a retail investor, it is difficult for you to anticipate what will happen. So, read analyst reports to form your own opinion. And I almost forgot about one point, payout ratio. Say, the company XYZ is paying out 95% of their retained earnings as dividends. The dividend is not safe.
Either they need to cut dividends to fund projects. Or they need to increase retained earnings. Or they might need to take debt to pay a dividend. So avoid companies with a lot of debt, high payout ratios like the plague. You can find a payout ratio on sites like Yahoo.com or India. Check out Screener. in.
You need a company that has a future, something like a utility company that has a visible future, low competition. So earning is predictable. But in most cases, those are heavily indebted. They often take a lot of debt to take over other companies and fund their expansion.
How do I select my stocks To Generate Annual Income?
My strategy is to supplement my income with dividend checks from companies that produce a lot of cash. You can do the same. But do your research on picking the companies; you cannot just use screeners and invest. I tried to cover the factors you will need to consider so that you do not chase yield and make a bad investment.
You can scroll through Yahoofinance.com articles for some ideas. Or you can go to Fool.com. They are publishing some ideas every other day. Forbes.com publishes some ideas too.
But once you get the name, do your research. Remember, you do not pay the analysts. And your financial wellbeing is not their primary concern. In fact, they probably own those stocks they are recommending, and you know why they are urging those. Always remember, nobody cares about your money the way you do. Show that love and do some work.
I do not focus on the dividend yield that much. Since I have a long way to go, I focus on stocks that have good return ratios. That means a high return on equity, high return on capital, meager to no long-term debt at all. And if it pays a 1 or 2% dividend yield, that would be great. I check the payout ratio, too; I expect the payout ratio to be less than 50%, as OI expects the firm to invest the retained income in growth rather than paying the maximum cash as dividend or buyback.
But, you might take a different approach, depending on your situation. If you are about to retire, focus on dividend aristocrats. But if you are in your thirties, you can take a basket approach by buying dividend ETF or buy stocks that generate significant returns and additional annual income from the dividend.
Always remember debt kills a company more often than you can think. So, be vigilant of the financial health of the company.
Have you made any investment in dividend-generating stocks? How did you pick the stock? And do you have any questions based on what you just read?