I am from India and I live and work in the USA. The capitalistic market gave me the perfect opportunity to find out more about the capital market. While I do not hate my job, but I do explore other ways to supplement my income. And I found out investing in stocks can help me grow my wealth and the dividend I earn from my investment is perfectly passive.
So, which dividend stock is the best passive income source? Any great business with huge free cash flow, brand recall, low debt, low payout ratio, and high-interest coverage ratio can be a great dividend stock, provided it has a good dividend yield that we like. If you are not sure about all these numbers, play safe, go for an ETF from vanguard or just S&P 500 index fund.
Identifying a great business with a long runway that is well managed is very critical. Because, a Warren Buffet says, the best time to sell a stock is never. Or Like the founder of Vanguard Jack Bogle said, own everything and sell nothing. Having an owner mindset is important. And buying a business just because the dividend yield is high will most probably make you repent your decision.
Like I did, when I purchased Frontier communications. That company had a ton of debt, a shrinking business, as a result, the business had to suspend dividend and the stock price crashed. I made a bigger mistake, I took the loss and sold the socks. I believe they have reinstated the dividend. But that does not mean it is a safe stock again. Passive income means you want to set it and forget about it.
How frequently we get the dividends?
In my experience, most stocks/ businesses/companies pay a dividend every quarter. If you trade on Robinhood, you will get a notification whenever a company declares a dividend. You will find the details of the dividend per share and the total amount in the history tab. It tells you the date too when the amount is going to be credited in your brokerage account.
Which stocks pay dividends and which don’t and why.
Some growing companies do not pay dividends. Now there are mainly two types of companies, first – companies that do not make any profit or free cash flow, cannot and should not pay a dividend, although if they wish to, they can take debt and payout that money as a dividend. If any company takes debt to pay you a dividend, first you should thank the management for letting you know how stupid they are and then you should sell the stock.
The second type of company that does not pay a dividend is profitable and probably has free cash flow. One example is Berkshire Hathway. But, they do not pay out a dividend, because they believe, they can reinvest the cash in other businesses and grow the money faster.
You will see most other matured businesses which generate a ton of predictable cash flow, pay a part of their free cash flow out to shareholders as dividends. Most commodity stocks, utility stocks, REITs, MLPs have predictable cash flow and they reward the shareholders with a handsome dividend.
Why do companies pay a dividend?
Only the CEO would know the accurate answer.
But, one way the company wants to build a shareholder base that is loyal.
Secondly, it wants to send out a signal that financially it is doing fine.
Thirdly and theoretically this is the correct reason when the company generates more cash than it knows what to do with it, it distributes that within shareholders.
How else a company rewards a shareholder other than paying a dividend?
Other than paying a dividend, the company can decide to split the stocks, issue bonus shares, bring rights issue and buy back stocks.
Splitting stocks does not really benefit shareholders, it creates many more outstanding common stocks, and may make the stocks affordable and easy on eyes for retail investors.
Bonus shares do the same thing, although for some weird reason retail investors become happy thinking that now they have more shares. Well, have you noticed the share price dropped?
Buyback is the only instance where the number of outstanding stocks shrinks and that benefits existing shareholders, the earning per share goes up, and dividend goes up.
What do we know about the management when it rewards the shareholder?
In theory, the management or board should fiduciary for retail investors/ shareholders. But in reality that does not happen all the time. Companies make accusations which often turn out to be a failure with hope to expand the business. Coke once purchased movie studio, and yes that diversification tactic failed.
Instead of trying to diversify and waste cash, the company can simply return the excess cash to shareholders as dividend and buyback. Often that gives a signal that the management is not incompetent. Buyback is tricky when the management is buying back while the stock price in the market is actually lower than intrinsic value, that is the right time to buy back stocks from the market so that the business does not overpay.
Top mistakes made by new dividend investors and how to avoid them.
The mistake I made was to use a screener app and buy those high yielding stocks. That was a huge mistake. The top dividend stock prices often go up in a low-interest environment. Because many people are hunting for yield. Especially retired people need steady income flow. The high yield dividend-paying stocks can be a good source of income or cash flow.
But, buying any stock without verifying quality is the worst kind of mistake. Highly indebted companies with no future in business often tend to pay a high yield, because somehow they are trying to attract investor, but the market does not trust them and does not think that this company will be able to continue paying this dividend yield for long. And as retail investors, we fall in this trap and lose money.
Gamestop is a recent example. They were yielding around 8% before they announced that they would not pay dividend anymore and then the stock tanked.
What is Passive Income?
In this post my passive income I mean, you do the work upfront. Like do research on selecting stock then you buy some shares, preferably on Robinhood, because you do not pay any commission, then you get paid the dividend every quarter. And the only work you can do after that is to check the financial health of the company every year.
If you do not want to do that either, then just buy ETFs and collect the dividend every quarter.
Why Dividend is the perfect passive income?
As I said, passive should be completely passive. It is like a set and you can forget it. Dividend income can be passive. You buy S&P 500 ETF and you can almost forget about it. And you will continue receiving the dividend in a brokerage account as long as you own the ETF. Y
ou do not have to sell the ETF if you do not want to. You can withdraw the dividend from the brokerage account or you can buy more ETF with the cash. Do whatever you want with the cash. Important point is, it is absolutely passive.
Is dividend a guaranteed income?
No, it is not. No company is legally bound to pay you a dividend. And moreover, what if none of the companies make any profit in the S&P 500 index. Most probably there will not be any dividend payout. But I am describing a highly unlikely scenario. Most probably the companies will make a profit and they will payout some part of cash flow as a dividend.
But again, it is not guaranteed, and you can do all your research and find the best possible company, but still, my answer would not change.
What are the factors to check before buying a dividend stock?
Focus on free cash flow, dividend history for any company you are considering to buy. More importantly, look for low debt to equity ratio, low payout ratio, preferably less than 50%, and very high-interest coverage ratio. If possible you should search for companies with a long runway or life, so that it makes sure that the company will produce free cash flow for a long time to come.
Do you need to pay tax on dividend income?
If you are in the USA, yes you do. The tax rate would vary for qualified vs non-qualified dividends. When you get tax document from you broker at end of the tax year, the document will indicate how much of the dividend amount is qualified and how is non-qualified. You, tax consultant, would be able to guide you more on this.
How much dividend income you can earn?
There is no limit to it. Your income will be determined on 2 factors, to begin with, the dividend yield of the stock you want to buy and how much capital you are investing. For example, you buy XYZ stock that pays 5% yield worth $10,000, at the end of the year you will get $500 as a dividend. That means every quarter you will get around $125.
But, do take a not that the dividend payout might go up or down which will impact the dividend yield. The price of a stock might go up or down, that will impact the dividend yield too, even though the payout ratio is constant.
Can dividend paychecks replace your regular monthly salary?
If you can invest enough in stocks which would pay dividend more than or equal to your yearly income, then, of course, you can quite your work and do whatever you like. And I personally am trying to do just that. But then, keep in mind, the capital needs to appreciate and dividend income must go up to keep up with inflation, I have written another post explaining all this, you can read it here.
Should you buy multiple dividends paying stocks?
Never keep all your eggs in one basket. I am personally buying high dividend-paying stocks such as BP PLC, Royal Dutch Shell, etc. Although the examples are from the same industry, you can consider buying AT&T, Verizon, etc, to diversify among sectors and the best is to buy an ETF, which fidelity and Vanguard offers.