Dividends are regular payments some companies make to certain shareholders, based on a percentage of company earnings. Because dividend-paying stocks tend to be well-established, some investors seek out dividend income because it can be reliable.
That said, dividend payouts can change as company earnings wax and wane, and some companies even cut dividends.
So, while dividends can certainly be part of an income strategy, unless you invest a substantial amount in dividend-paying stocks, it might be challenging to live on dividend income alone.
Key Points
• Dividends are a percentage of earnings that a particular company may pay to eligible shareholders on a regular basis (e.g., quarterly).
• Dividends can be paid as cash or as additional shares. Investors can take their dividends as income, or have them automatically reinvested in more shares.
• Investors who are seeking a steady stream of income, in addition to price appreciation, may find dividend income appealing.
• There are no guarantees that a company will continue to pay dividends over time, thus living off dividend income alone may present some challenges.
What Is Dividend Income?
To understand how you can use dividends as part of an income investing strategy, it’s important to understand what dividend income is.
Dividends are payments made to eligible shareholders, based on a percentage of company earnings. In order to earn dividends, an investor must buy dividend-paying shares of a company that pays dividends (not all companies do, and not all types of shares pay dividends).
Many companies pay dividends quarterly, but some may have a monthly, semi-annual, or annual dividend payout schedule.
Dividend income is distinct from a stock’s capital appreciation. You don’t need to sell an asset to earn dividends from it; if you did, you’d no longer be eligible to collect its dividends.
Some companies might also pay out “special dividends,” or one-time payments, often after an event or performance streak that leads to excess cash in the company coffers.
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How Much Do Dividends Pay?
Dividends are calculated by the company based on available profits, and may vary over time. The dividend payout amount is declared on the dividend announcement date and must be approved by a company’s board of directors before it can be paid out.
Because the amount is variable, dividends aren’t always a reliable income source. Moreover, some companies may even cut or suspend dividends if they hit a rocky period.
That said, understanding key metrics such as dividend yield, dividend growth rate, and dividend payout ratio may prove helpful when deciding whether to invest in a certain company, whether you invest online or through a brokerage.
What Can Dividend Income Be Used For?
Dividend income is just that: a type of income. And while many investors choose to reinvest dividends to increase their passive earnings, these payouts can also be used for day-to-day living expenses, for savings, or any other goal.
Dividend income can help retirees supplement their income. Dividend income represents an additional cash flow that could make living on a fixed income more flexible, comfortable, and sustainable.
Is It Possible to Live Off Dividend Income?
It’s true that dividends can provide a steady stream of income, but for many investors dividends would be a modest source. Even if you’re willing to live below your means, it would take time and resources to create the kind of substantial portfolio you’d need to live on dividend income alone.
After all, dividend payouts directly depend on a company’s profits and, thus aren’t always dependable. That means you’ll probably need to flesh out a diversified portfolio of dividend-paying assets to create enough income to sustain even a low cost of living.
That’s why many investors thinking seriously about living off dividend income are retirees: they’ve had years to curate and fund a robust portfolio that can support them on dividends alone.
In retirement, it’s a good idea to have several income streams to rely on, such as capital gains from different types of retirement accounts, Social Security benefits, or a pension.
That said, if you’re hoping to earn some income on dividends, whether in retirement or your working life, it’s important to invest with that goal in mind from the start.
Investing for Dividend Income
Earning dividend income involves investing in stocks that pay dividends. But not all companies pay dividends to their shareholders, and even among those that do, dividend amounts can vary considerably.
Therefore, it may be worth focusing on companies that offer investors the opportunity to earn dividend payments now, as well as those that offer dividend amounts that increase yearly.
This may mean striking a balance between mature companies and newer ones experiencing dividend growth — meaning their dividend payouts may increase.
Dividend growth is a powerful tool in the pocket of any investor, whether or not they hope to live off dividend income alone. It offers shareholders the potential for higher returns, especially when dividends are reinvested into the investment for longer-term gains in a dividend reinvestment plan (DRIP).
Recommended: How Often Are Dividends Paid?
Dividend Investing Calculations and Metrics
For investors interested in earning dividend income, here are some of the valuation metrics to know about.
Dividend Yield
Dividend yield is a ratio calculated by dividing a company’s annual dividend payout by its share price (dividend/price) and expressed as a percentage. This is one metric that helps investors assess the relative value of a dividend payout between different companies.
For example, if a stock trades at $50 per share, and the annual dividend is $1.50 per share, the dividend yield is 3% ($1.50 / $50 = 0.03).
If another company’s share price is $30, and also pays an annual dividend of $1.50 per share, the dividend yield of the second company would be 5% ($1.50 / $30 = 0.05).
How to interpret dividend yield? A company with a high dividend yield is generally a more mature company — one that has enough profits to offer its shareholders a decent yield rate, but which might not be seeing very much growth and expansion at this point in its life cycle.
On the other hand, a high yield could be a sign of a falling stock price that could indicate troubles at the company such as impending bankruptcy. Also, remember that dividend yield fluctuates based on the underlying stock price. So it’s important to consider company fundamentals because the share price determines the consistency of the dividends.
Thus, it’s also important to consider another metric: dividend growth rate.
Dividend Growth Rate
The dividend growth rate measures how a company’s dividend payouts change over time. It’s expressed as a percentage and refers to the amount of growth in dividend amount compared to the previous year.
Although it won’t tell you as much about how much you might stand to earn from a given company in dividend income, the dividend growth rate gives you an idea of the company’s growth potential, and may help you make decisions that increase your total dividend income in the long term.
Dividend Payout Ratio
Dividend payout ratio is calculated by dividing the total amount of dividends paid to shareholders by a company’s net income. This can give investors insight into what percentage of a company’s profits are being paid out to shareholders as dividends.
While it may seem like a higher dividend payout ratio is better for the investor, that’s not always the case. If a company is hemorrhaging all of its profits and not reinvesting anything in growth and development, it may not be able to sustain its performance long term.
On the other hand, a low dividend payout ratio may indicate a company hasn’t yet matured enough to funnel much of its earnings into dividends, which might mean the company still has room for growth.
Building a Healthy Investment Portfolio
If you’re a beginning investor looking to create a well-balanced portfolio, the standard investing advice applies whether or not you’re focused specifically on dividend earnings.
Since all investments come with risk, a diversified portfolio can help you mitigate certain market or sector-related risks. And you may want to rebalance your portfolio periodically to make sure you’re not leaning too heavily on one asset or another.
Diversifying Your Investments
Diversification can be valuable as it helps to mitigate certain market risks. By adding a wide variety of companies from different sectors and categories, to your portfolio, you’ll have a better chance of riding out volatility without seeing major losses.
When it comes to dividend income, diversifying your investment portfolio is also critical: Even companies that pay higher dividends consistently might encounter a period of poor performance, and some companies with the highest growth potential may not be paying out an appreciable dividend right now.
Diversifying your dividend-paying assets can also help you earn the most dividend benefits, potentially maximizing your returns over time.
Continuing to Fund Your Account
As research shows, it’s important to invest funds steadily over time. With this strategy, you’re continually adding to the assets in your portfolio, giving them a chance to grow through both appreciation and through dividend income.
There are many ways to automate this process: for example, the strategy known as dollar cost averaging allows you to invest consistently, and that regular cadence can help manage volatility. In many cases, you can simply set up an auto-transfer to have a portion of each paycheck contributed to your investment account.
The Takeaway
Dividend income, which consists of regular payouts that certain companies make to eligible shareholders, can be a vital part of an investor’s income strategy. And some investors do live on dividend income. But creating a portfolio that delivers sufficient income only from dividends, may be difficult.
In most cases, people who derive their income from their investments rely on a mix of different types of payouts: e.g., bond yields, stock market gains, and more.
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