Using Dividends to Build an Additional Income Stream
Whenever a company makes a profit, they have a couple of options they can consider. They can either invest the profits back into the business in hopes of further growing the business, or they can disperse their profits to their shareholders in the form of a dividend. Dividends effectively offer investors a way to purchase a long-term income stream, and while the returns are not typically anything to flaunt, they are often extremely consistent. Keep reading to learn how you can build an additional income stream using dividends and utilize the effects of compounding interest.
What is a dividend?
By definition, a dividend is “a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves).” Dividends are a way for a company to reward investors for their capital and also a way to attract potential investors to invest in their company. Dividends are commonly offered by more mature companies who have a firm foundation and consistent financial performance.
When and how often are dividends paid?
If offered, dividends are typically paid quarterly and are dependent on the companies fiscal calendar. You can find a list of stock dividends and when they are paid below.
What happens if I sell a stock? Who will receive the dividend?
Stocks that offer dividends will have what is called an ex-dividend date. This date is what determines who will receive the dividend payment. If you sell a stock before it’s ex-dividend date, you will not receive the payment. It is common that you will pay a premium to purchase stock right before it’s ex-dividend date, so be sure to consider that when valuing the stock and deciding whether or not to purchase it.
How much do dividends pay?
The amount of your dividend is dependent on the companies profits and the board of directors' decisions. The board of directors can choose to raise, lower, or cease the payment of dividends based on company performance. You’ll often find that a growing company will consistently raise it’s dividend while a company that is slowing will either maintain or lower its dividends. On average, you can expect a company that pays a dividend to yield between 2 and 2.5% annually.
How do dividends compound?
Whenever a dividend is paid, you have the option to reinvest this capital or keep it to yourself. If you’re looking to grow your income stream, reinvesting it is the obvious choice.
For example, if you owned 100 shares of AT&T stock, which currently pays a quarterly dividend of $0.52 per share, you would receive a payment of $52.00 each quarter or a total of $208 for the year. With the current price of the stock hovering around $40 per share, you could purchase an additional share of the stock after one quarter, or roughly 5 shares after the first year.
The next year, your dividend income would increase to a total of $218.40 because of the additional dividend payments from your additional 5 shares. This example is compounding on an annual basis and not quarterly. The sheet below details the effects that compounding interest can have on your dividend income. You'll notice that after year 9, you will bring in over $300 in dividend income, a 45% increase from year 1!
If you were to purchase an additional share after each quarter, your dividend income would exponentially increase. We also assume the dividend will not increase and the stock price remains at roughly $40 per share throughout these calculations.
Best Dividend Stocks of 2020
Dividend stocks tend to have something in common between them. They are commonly large, mature companies that have low and possibly even slowing growth. For that reason, you‘ve probably heard of these companies at some point as a consumer.
AT&T is most known at the telecommunications carrier covering the US. Currently, they offer a whopping 5.43% dividend yield, making them a favorite among income investors. AT&T has paid its quarterly dividend 10+ straight quarters, making them a reliable source of income.
Carnival Corporation is most known for its travel and cruise line. Currently offering a 4.7% dividend yield, Carnival Corp is another great investment for those looking boost their dividend income.
With almost half of American’s drinking soda on a daily basis, Coca Cola is an obvious choice when it comes to dividend investing. They offer a 2.9% dividend yield and have paid a dividend for more than 50 consecutive years.
You might think of Pepsi or Mtn Dew when you think of Pepsi Co, but that’s just the surface of their offerings. Pepsi Co also owns Frito Lay, Quaker Oats, and much more. Their diversified portfolio of brands has helped them achieve a 2.61% dividend yield and consecutive dividend payments since 1965.
Why build an income stream with dividend stocks?
Dividends are a reliable way to produce long term income. When it comes to investing, your goal should be to maximize your risk-reward ratio. Dividend stocks will offer you a stable source of income that is lower risk than most growth stocks.
Do you need another reason to consider dividend investing? For most income streams, the initial investment can be rather large. But with dividend investing, this isn't necessarily the case. You can get started with any stock that offers a dividend, which can often cost less than $10 for one share. As long as you keep reinvesting your dividends, you'll keep your income stream growing.
Dividend, or income stocks, offer investors a great way to receive long-term income in the form of cash payments. This money can then be used to reinvest or it could be put towards a separate financial goal. Because dividends are typically paid on a quarterly basis, you can easily create an additional income stream using dividend payments alone by purchasing more shares with your dividends. Companies like AT&T, Carnival Corporation, Coca Cola, and Pepsi Co offer relatively high dividend yields with a superb track record of paying and increasing dividends over time.
Need some help calculating your potential returns? Check out this dividend income calculator!