Passive income is the goal for anyone who wants their money to work harder than they do. This is a common idea and is talked about throughout many personal finance books. But it is not as simple as just snapping your fingers and making it happen. Like any goal, it must be worked for. A great place to start is by purchasing stocks in great companies that pay dividends. Many “Blue Chip Stocks” or the large powerful companies that are frequently household names, pay a portion of their quarterly income out to their shareholders as a dividend. The amounts paid can range from quite small, almost token payments, to dividend payments that are actually pretty generous. These payments are referred to by their yield (yearly dividend/price of the stock). Buying stock-strong companies that pay a generous yield can provide an nice amount of extra income over and above any appreciation you can earn in the stock itself.
Examples of Dividend Yields
Verizon (VZ) is currently yielding 4%
Apple (AAPL) is currently yielding 2.8%
Waste Management (WM) is currently yielding 3.5%
Marriott (MAR) is currently yielding 1.6%
JP Morgan Chase (JPM) is currently yielding 2.7%
Those are just a few examples, but you get the idea. Of course, the yield changes with the price of the stock. As of this writing, Verizon is trading at $50.42, and the yearly dividend is $2.06. So $2.06 divided by $50.42 gives you a yield of 4 percent. If the stock price were to increase and the dividend payment stays the same, the yield would drop. And if the price dropped and the dividend payment stays the same, the yield would increase. You get the idea.
So how do you pick good companies that pay dividends? Well, my advice is, “Never pick a company just for the dividend. The dividend is a bonus.” There are companies out there that pay enormous dividends (20 percent plus). This means that the company is paying out a huge amount of their earnings every year. If you think about it as if it were your income it makes sense. If you work for a year and earn $50,000, but you spend $45,000 per year, that leaves very little for emergencies. It is the same with companies. If a company spends almost every penny they earn, if anything goes wrong, they do not have the money to fix it. In that situation they may have to drop or eliminate the dividend. That is not good for your income or for the stock price. (In a situation like that, the stock will plummet.)
What you want is a great company with a strong business that earns tons of money. That company then returns some of their earnings back to their shareholders. Just look at JP Morgan Chase as an example (one of the largest banks in the world). In the last 12 months, they earned $5.98 per share. They paid out $1.52 in dividends. So they are paying out about 25 percent of their earnings. This leaves them plenty of safety room. If something happened in the business that they did not expect, they would have plenty of room to fix it, without reducing (or eliminating the dividend). That is the kind of strength you want to see in the companies you invest in.
Finally, some of you may be thinking, “How is this helpful? Verizon pays me $2.06 per share. So what?” Well, remember that you probably own more than one share. If you owned 100 shares of Verizon, then you would get paid $206 per year in dividends from that position. As you build positions, you can gradually increase your dividend income. Any income you didn’t have to work for is great. And dividend income is taxed at a much lower rate than earned income. So it’s a win win.
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