How to Earn Passive Income From Dividends - SmartAsset (2024)

The premise of passive income is attractive because who wouldn’t want to sit back and watch their extra cash silently earn more money without doing any additional work? However, generating passive income is easier said than done. It only comes from legitimate opportunities with the potential for substantial returns. Dividends are a regular payout of your share of company profits when you own stock in a business and this type of investment can meet these requirements. Consider working with a financial advisor to help you determine how dividends might factor into your investment strategy.

What Are Dividends?

Dividends are financial returns investors receive for holding stock in a company. When a company is profitable, shareholders receive dividends as a reward for the risk of owning their portion of the business. They can come in the form of cash payments or stock dividends.

How Dividends Work

When a company makes money, it has a couple of options for what to do with the cash: reinvest in the business or pay dividends to shareholders. If it chooses the latter, each investor obtains a reward according to how many shares they have. For example, let’s say a company issues a cash dividend of $1 per share. In that case, a shareholder with fifty shares would make $50 from their investment.

A company also might issue a stock dividend instead. Using the same example, if the company approves a 10% stock dividend, the shareholder would receive a proportional amount of additional stock. As a result, they would take ownership of five additional stocks for a total of fifty-five stocks. While the resulting stock dilution would make the total value of their holdings the same as before, and a jump in the stock price would be increasingly profitable.

How to Find the Best Dividend Stocks

Receiving dividends every quarter, month or year is an excellent passive income source. Therefore, finding companies that pay out regularly and have a history of success is crucial. Use the following tips to find the best dividend stocks.

Invest in Companies with Reliable Track Records

Just because a company is worth billions doesn’t mean it’s an ideal investment. The company also needs to pay dividends to its shareholders. As a result, it’s a good idea to check the U.S. Securities and Exchange Commission (SEC) disclosures for records of dividends paid in the past. Generally, a company that has paid its shareholders for the past several years will continue doing so. On the other hand, a company with high earnings but no history of dividend distribution may be an unreliable investment for increasing your passive income.

Additionally, balance is a factor to prioritize. While a company that pays every last penny of its profits as dividends sounds fantastic, it’s not a sustainable practice for a company to have a payout ratio of 100%. In reality, a company that makes steady dividend payments of no more than 60% of its earnings is a strong investment. This way, the company will use some of its earnings to maintain and grow the business, providing even higher returns in the years to come.

Profitability and Robust Cash Flow

Companies that generate substantial income are more likely to pay dividends. On the other hand, a company that reports year-over-year losses will probably suffer stock price decreases and shrink its business operations.

Therefore, cash flow is vital. A profitable company is likely to have better cash flow, which leads to a higher probability of dividends. Looking through a company’s financial reports can help determine whether sizable amounts of money regularly go in and out of its accounts. You’re not necessarily looking for the business with the flashiest product or an initial public offering (IPO) that makes headlines, you’re looking for businesses sitting on piles of cold, hard cash.

Earnings are a critical part of the picture; it’s tough to have cash flow when a business isn’t making more than it’s spending. As a result, checking income projections can help you gauge how likely a company is to pay dividends in the future. Generally, companies forecasting growth of at least 5% over the next several years can provide dividends to their shareholders down the line.

Avoid Debt

Just as cash flow signifies a company’s ability to pay dividends, debt can be a sign that money won’t be flowing an investor’s way. While not all debt is crippling, a company with a debt-to-equity ratio of 2.00 or higher might not be the best investment. Profitable companies with massive debts will likely divert excess cash toward their loans and lines of credit. While taking care of financial responsibilities makes sense for a long-term business plan, it’s not profitable for shareholders. As a result, steer clear of too much debt and focus on companies that are free to use their cash as they wish.

Assess the Industry

Part of doing your homework on a company is considering the wider economic context. Market dynamics and patterns in a specific sector are as significant as a company’s cash flow. For example, a company that has a few strong quarters in a dying industry might not be around in a few years to continue paying dividends.

Conversely, biotech has been a profitable investment for years and will likely continue with the boom of vaccine and antiviral products that resulted from COVID-19. Because medical necessity and international government dollars drive it forward, biotech companies will have plenty of room to grow their business without cash flow issues.

How to Create Passive Income From Dividends

After researching companies that will provide dividends, you can construct a dividend portfolio. Ideally, your assortment of stock holdings will generate passive income once you make your purchases and hold the assets for a little while. However, no investment is a guarantee. Take the following steps to maximize your passive income and cover your risks.

1. Use Dividend Payments as Investments

Reinvesting dividends is an excellent way to increase your passive income. Instead of pocketing dividends, you can use them to purchase additional stock. By increasing your exposure to the companies you’ve chosen, you have higher income potential than before. Reinvesting for multiple years can double your passive income generation. That said, investing always comes with risk, so you also have a chance of losing your extra investments.

2. Time Is on Your Side

Even if your investments seem weak initially, the stock price should increase over time. If you’ve done your research correctly and invested in companies with solid foundations, they will find success, resulting in stock growth.

Additionally, because your stock purchase price is a fixed cost in the past, you benefit the more time passes. In other words, the longer you hold a stock, the more opportunities you have of receiving dividends. For you to make passive income, a profitable company’s stock price doesn’t need to skyrocket. It only needs to keep passing along profits to its shareholders.

3. Be Mindful of Risk

While dividends are excellent as a passive income stream, they can fail. Like any other investment in stocks, bonds, real estate and other assets, there’s a chance your dividend holdings will go south. Specifically, one or more of the companies you invest in may experience years of stagnation or go out of business.

The risks involved are why diversification is essential. In this context, it’s wise to diversify on two levels: firstly, in your investment portfolio, and secondly, in your passive income streams. You can never eliminate risk entirely, but you can reduce it. Don’t put all your eggs in one basket; instead, thoroughly researched investments among a variety of assets and opportunities will provide more reliable returns.

How Much to Invest In Dividends

Your investment in dividends will depend on the stock price, projected returns and your overall financial strategy. For example, let’s say you have $50,000 to invest and have found a company with a stock price of $1,000 per share and a 5% projected annual yield.

Buying five stocks creates $250 of annual passive income, and your goal is to establish $2,500 of passive income per year. As a result, you realize that you could spend your entire investment fund on this company’s stock and reach your goal: $50,000 of stock would create $2,500 in profit annually.

However, investing solely in this company will give you no chance of diversifying your portfolio, and if this one company goes under, you will lose your entire investment fund. Since diversifying helps weather market volatility, it’s probably wiser to put a portion of your money into this company and look for others as well.

The Bottom Line

Dividends can create hundreds or thousands of dollars of passive income every year. For investors willing to do their homework and mitigate risks, a collection of stocks among numerous profitable companies in different industries can weather economic storms and provide a stream of income in perpetuity. It’s important to figure out how these assets can work with your overall financial plan and asset allocation to maximize the benefit to your long-term financial goals.

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