How to Invest In Stocks For Dividend Income - The Humble Penny (2024)

How to Invest In Stocks For Dividend Income

Hey guys, something very interesting happened over the recent holiday period.

My male friends chose not to buy their partners conventional presents such as jewellery and clothing, etc

Instead, they chose to buy them stocks in companies as gifts.

Whilst I thought that was such an amazing thing to do, buying a partner a really meaningful present…

What was even more remarkable was that the stocks they were buying were dividend generating stocks.

Ones that could potentially help them to build wealth time and time again.

Most people do not realise that the vast majority of the returns of the stock market comes about by reinvesting dividends.

I.e. rather than taking a dividend out as income, you'd reinvest it to compound and grow.

The beauty of this compounding process is that it requires time to work.

This is another reason why real wealth creation comes by seeing investing as a long term thing.

By long term I mean at least 10 years, although you can ofcourse invest for shorter term goals.

This chart (from Hargreaves Lansdown) is an illustration of compounding at play:

It looks at £10,000 invest in the UK stock market 30 years ago and dividends reinvested vs not reinvested.

It would become £106,000 if reinvested compared to about £35,000 had you not reinvested dividends at all.

The results in the above chart only go up to 2017 and look much better now.

This chart shows you that reinvesting in dividends is hugely powerful.

Today we're going to look at how you can take the steps to start to invest in dividends for passive income.

Whether you are investing through individual companies by picking stocks, or through funds, e.g. index trackers and ETFs.

Dividends have become very popular for people who are either:

• Building a portfolio to generate ongoing income or
• people who are building their wealth over time and working towards goals such as financial independence.

What Are Dividends?

Dividends are distributions of a company's profits periodically to its own shareholders.

The key there is that a company generates profits and then it distributes some of those profits to its shareholders.

Any remainder of profits is then retained to reinvest into its operations such that that business can then grow over time.

How To Earn Dividend Income

There are two broad ways to invest to generate dividend income.

1. Invest In Dividend Income Generating Companies

These are companies that essentially pay you dividends over time.

They tend to be large blue chip companies. E.g. Unilever, WPP, HSBC, etc.

A sample list can be found here, for example.

These companies have it in their policy to reward shareholders periodically by paying them dividends.

It is their way of returning money to shareholders, with the alternative way of doing this being a share buyback.

See chart further below of an example of dividend income from Unilever (Ticker: ULVR).

2. Invest for Dividend Income via Funds

A lot of people are unaware that funds pay dividends because those funds go on to invest in the same companies that you might be investing in by picking individual stocks by yourself.

The key difference between investing in individual companies and investing via funds is the risk of investing in individual companies.

Whilst you stand to be paid dividends, you are potentially also putting in lots of your eggs into one basket.

Whereas with funds, you stand to get a lot of diversification because the specific risks you have tied to individual companies is reduced.

All you have exposure is the market risk that all investors face by investing through the stock market.

Each of the various methods for investing for dividends have their various merits.

There is a lot of fun and interest in trying to invest in individual companies to generate dividends.

Some do it for sentimental reasons because they might love a particular brand, etc.

But as I mentioned earlier, that comes with a warning risk.

This is why doing the work involved to identify the right type of companies, mainly blue chip companies to invest in, is definitely worth your while to do so.

There is also a fundamental difference in approach to the stock market i.e. someone picking individual stocks is more likely to focus on timing the market.

They’d worry about whether a stock is too expensive, for example.

Whereas an investor in funds, particularly index trackers like Index Funds and ETFs is more concerned about time in the market.

Here is an example of dividend income being paid by a popular Vanguard Index Fund (ticker: VWRL):

Here is another example of a Vanguard Fund of Funds (LifeStrategy 80%) paying dividend income:

To see these, simply click on the “distributions” tab for any fund on Vanguard.

The above funds are not recommendations, merely illustrations.

How To Choose Dividend Income Stocks

There are three things you should be looking at when it comes to generating dividend income.

Dividend Yield

You want to invest in a company that has an attractive dividend yield.

A dividend yield is defined as the ratio of the dividends paid, i.e. the dividends per share divided by the share price of a company.

That ratio of the numerator and denominator gives you a percentage and that percentage is known as the dividend yield.

Here are examples of dividend yield of various companies:

Focus on the Forward Yield % as that uses the forecast share price of the company from analysts reports.

Now ordinarily you'd want that number to be as high as possible.

However, that number also carries a bit of a warning because a high dividend yield does not always equate to being a good thing.

That’s because the numerator, the bottom part of that equation is the company's share price.

Simple maths would tell you that if the share price of a company falls and you divided the numerator by a lower number, it will make that dividend yield number go up.

This would mean that you might be thinking that this company's paying a much higher dividend yield, when it actual fact, it is the result of falling share price.

So although looking at the dividend yield is something to watch out for, looking for dividends that are really high, i.e. chasing high dividend yields can come with its own risks.

I'd highly recommend any dividend yields that are anything near 8% and above is usually a red flag.

It's something you should really aim to avoid, but the key is to look at a dividend yield in conjunction with the other metrics below.

Dividend Cover

This looks at how sustainable the dividends that accompany is paying would be in the near future.

The best indicator of the sustainability of dividends is to look at something known as the dividend cover.

This looks at the ratio of a company's profitability to the level of dividends that it pays in a year.

So it's a simple ratio of profits in a year divided by the dividends paid.

This gives you a ratio of something like one point something or two point something.

The higher that number the better because it shows that a company is able to comfortably pay dividends out of the profits that's generated.

But where you start to see numbers like nearer to the number one or the numbers such as zero point something, those should be red flags.

They start to suggest potentially that a company paying those dividends potentially might not be able to sustain those dividends into the near future.

Another place to look for this sustainability of dividends is to look at a company's financial statements.

In particular, look at the notes to the accounts or the director's statements.

These usually give an indication from the board of directors of where they see the direction of the company going and what they see their dividend policy looking like in the very near future.

Beyond looking at just a dividend cover, you also want to look at the qualitative information that you can find in the financial statements.

Dividend Growth

This measure looks at sustainable earnings.

Dividend growth is defined as the percentage change in the dividends a company pays from one year to another.

You can look at this over a period of say three to five years and see how the dividends have potentially grown over time.

A good indicator and the main drivers for dividend growth are typically the revenue growth of a business over time.

This then drives the profit growth of that business as time passes because it's only through those profits (Retained Earnings) that a company could pay dividends.

So looking at the dividend growth, combined with the dividend cover as well as looking at the dividend yield can start to paint a very realistic picture.

Here is a simple example of those 3 metrics displayed here at Hargreaves Landown for Unilever (Ticker: ULVR)

To make this super real, I have done a deep dive in this video using 2 examples of dividend income paying companies:

In the above video I also share with you information on how to review the fundamentals of a company.

I.e. how to review their statement of Financial Position (Balance Sheet) and Performance (Income Statement).

I hope that has given you a good intro on how to start to invest in dividend stocks for dividend income

What To Read Next>>

• How To Invest In Stocks With Confidence: Step-by-Step For Beginners
• What Is An ETF? A Complete Beginner’s Guide For Investing
• Compound Interest Calculator: Benefits and FREE Excel Calculator
• 10 Tips For Smarter Investing

Do you currently invest in stocks or funds for your dividend income? Why have you chosen to do it that way? Please comment below.

Do please share this post if you found it useful, and remember, in all things be thankful and Seek Joy.