How To Build Passive Income With Dividend Stocks

Published on
May 23, 2021

Why invest?

The big idea behind investing is taking control of your financial security and long-term wealth. Beyond having enough liquidity to cover a 6-month gap in income, also known as an emergency fund, which is no small feat and is the foundation for financial stability, there is little reason to keep your money in a checking or savings account. The interest on money market accounts, such as savings accounts, are usually less than 1% a year, a rate that makes it impossible to build wealth, let alone build a substantial income. There’s a lot more substance to investing than the common get-rich-quick schemes that abound on the internet promising outsized returns. This blog is for people who understand that if it sounds too good to be true then it probably is. What this article can provide is direction for those who want a strategic and predictable way to  invest their hard-earned money into assets that produce cash on a consistent basis.

Maybe you fantasize about living on the beach, or in the mountains without ever having to punch another clock again. Or perhaps you love your job and it's more about knowing that you have a side income that allows you to take professional risks in your career, such as pursuing passion projects or an entrepreneurial venture. Regardless of your journey, having a solid financial position will always leave you with more and better quality options when making a career pivot or just taking time off. A great way of building up your financial strength is by adding an additional income stream by way of dividend paying stocks.

Dividend stocks

So what exactly are dividend stocks, and how are they different from other non-dividend paying stocks? Public companies that choose to pay a dividend to its shareholders are usually mature companies with a healthy balance sheet and a history of steady cash flow. These are companies that have been around for a while and have established themselves as permanent players in their respective markets. They are no longer growing extremely fast and thus don’t need to reinvest all the profits of the company into growth. Instead they choose to reward shareholders with a dividend for owning the stock and this dividend payment is usually distributed every 3 months.

Financial Freedom vs Financial Literacy

So how can dividend-paying stocks help you build a side income that isn't dependent on any job? Before we get into that, it’s important to note that, like all stocks, dividend-paying stocks carry the same potential risk of losing money that all stocks of publicly traded companies carry. This blog should only serve as an introduction to the power of dividends and is not meant to be a comprehensive guide to investing, risk or dividend stocks. It is important to continue to learn and dedicate time to educate yourself on the language, concepts of investing and dividend stocks. But while I have you here, there are some key things that you can start to learn that can help you get started sooner rather than later. BTW, time is the biggest factor when it comes to building wealth, so start today!

4 Key Ratios to Look at when Investing in Dividend Stocks

Dividend Payout Ratio

The dividend payout ratio is calculated by dividing the annual dividends per share by annual earnings per share, or in the other words, the total amount of dividends paid out divided by the total amount of the company’s net earnings. So the concept is that you don’t want to see a company pay out too high of a percentage of its earnings in dividends, because that might prove to be unsustainable if expenses or debt increase unexpectedly. A healthy dividend payout ratio is 50% or less.

Quick Note: When evaluating a company's dividend payout ratio, investors should only compare a company's dividend payout ratio with its industry average or similar companies.

Example: REITs are Real Estate Investment Trusts, which are companies that own income-producing real estate assets and are required by law to pay out 90% of its earnings every quarter.

Dividend Coverage Ratio

The dividend coverage ratio is calculated by dividing the company's total net earnings by the total dividend declared; for instance, if the company made 100 Million dollars and decided to pay 20 Million in dividends, the coverage ratio would be: 100 Million / 20 Million = 5. A coverage ratio of 5 means the company currently has enough cash on-hand to pay the dividend 5 times. Obviously, the higher the coverage ratio the better as it indicates the company has more than enough cash to continue to pay the dividend.

Free Cash Flow to Equity

The FCFE ratio calculates the amount of cash that could be paid out to shareholders after all expenses and debts have been paid. This is also an important metric to look at because it tells you how the company is using its free cash flow and where it is going. It is a more difficult ratio to measure because you need to subtract net capital expenditures, debt repayment, and change in net working capital from net income and then add net debt. What you want to see is a company that pays out all of its dividends with free cash flow.

Net Debt to EBITDA Ratio

The net debt to EBITDA (earnings before interest, taxes and depreciation) ratio is calculated by dividing a company's total liability less cash and cash equivalents by its EBITDA. This ratio is also a little more complex because it introduces EBITDA, which is a measure of a company's earnings before subtracting many of the company's cash and non-cash expenses. The net debt to EBITDA ratio measures a company's leverage and its ability to pay its debts. Generally, a company with a lower EBITDA ratio, when measured against its peers or industry average, is more attractive. If a dividend-paying company has a high net debt to EBITDA ratio that has been increasing over multiple periods, you can suspect that the company is not decreasing its debt and might have to cut its dividend payments to meet its debt service.

I’ll leave it up to you to go and learn more about these, and in time you’re understanding will increase--but don't wait--become a practitioner!

Dividends on Dividends

The biggest advantage of dividend paying stocks is that as long as the company continues to pay the dividend, you'll receive real cash every 3 months; you don't need to wait and sell like non-dividend paying stocks to realize returns or profits. Owning dividend-paying stocks is one of the most legitimate ways in which you can feel like a true shareholder or owner of a company. Even if you only own a single stock, seeing that cash distribution hit your brokerage account feels awesome; it feels like you are truly building wealth. The trick is to truly take advantage of a little concept called Compound Interest, which is where the real wealth building occurs because you earn dividends on dividends.

Dividend Reinvestment Plans (DRIPs)

The method for building wealth through compound interest and thus earning dividends on dividends is to sign up for the company's Dividend Reinvestment Plan, or DRIP for short. This is an auto investment plan that automatically reinvests your dividends into more dividend paying stocks that'll then also pay you a dividend, which also then gets reinvested into more dividend paying stocks, again and again and again. Here's an example to illustrate the magic of compound interest:

Let's say you buy 10 dividend paying stocks of company ABC, which pays out every 3 months, and lets say for easy math the yield (the amount of cash the company pays out, expressed as a percentage) equals 2 free stocks per year; meaning the original 10 stocks pay out enough cash that you can buy 2 more stocks per year with that cash. That means that without having to invest another dollar out of your pocket, in 5 years time, you'll have doubled the amount of stocks you own and thus doubled your wealth.

YEAR 0 you own 10 stocks (original stocks and investment)

YEAR 1 you own 12 stocks

YEAR 2 you own 14 stocks

YEAR 3 you own 16 stocks

YEAR 4 you own 18 stocks

YEAR 5 you own 20 stocks

The magic starts to happen after year 5 because now your wealth has doubled and if it keeps growing at the same rate it'll take you less and less time to earn more and more dividends from your original investment, which was only 10 stocks. Below is a breakdown of the following 5 years.

YEAR 5 you own 20 stocks

YEAR 6 you own 24 stocks

YEAR 7 you own 28 stocks

YEAR 8 you own 32 stocks

YEAR 9 you own 36 stocks

YEAR 10 you own 40 stocks

The rate at which your wealth is growing has doubled and now the Dividend Reinvestment Plan is earning you 4 extra stocks per year as opposed to the 2 stocks per year you were earning in the first period. In other words, at first it took you 5 years to grow your original stockholding from 10 stocks to 20, but in that same amount of time in the second 5-year period, you grew from 20 stocks to 40. So to recap, in 10 years you grew your original 10 stock investment into a whopping 40 stock portfolio without every having to invest another dollar.

That's the power of Compound Interest.

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