Monday, October 1, 2012

Looking for Passive Income?

The two main way to meet personal financial goals is to save more by cutting expenses. The other way is to increase your income. There are only so many hours in the day to work and quite frankly working every waking hour may not be much of a life at all. One way to increase your income is by increasing it passively through investments. One of the best sources of passive income is through dividend paying stocks.

In Charles Carlson's "Little Book of Big Dividends", he goes through the basics of investing in dividend paying stocks. Given that you already know how to go about purchasing stocks, this book focusing on the process in which to choose solid companies that will likely be safe and will continually pay you through dividends.

So what are some of these important criteria that a stock must meet in order for it to provide big safe dividends. One concern is the dividend payout ratio. When a company makes money through sales it has to subtract costs to obtain its earnings. These earnings (if the company is making money at all) can either be reinvested into the company or paid out to shareholders as dividends. The percentage of the earnings that is paid out as dividends is known as the dividend payout ratio. For instance, if a company earns 1 dollar per share in earnings and pays 50 cents at the end of the year per share, than the payout ratio is 50% (0.5 divided by 50).

Carlson says for the dividend to be safe the payout ratio should be no more than 60%. That way some of the earning is kept within the business to allow for its growth.

Another main consideration is if the company has a history of raising dividends over time. This is critical because growing dividends helps your income keep pace with the increased cost of living (known as inflation). An additional screen would be to find companies that have consistently grown there dividends over the years. Inflation averages out to be about 3 to 4% per year, so dividend growth that exceeds that would be optimal.

A final word of caution is not to chase exceedingly high dividend yields. A dividend yield is calculated by dividing the dividend by the stock price. Say the dividend per share is 10 cents a year and the stock is trading at 1 dollar share. In this case the dividend yield would be 10% (10 cents divided by 1 dollar). That's a pretty sweet yield. Chasing high yields is tempting, but it can also be a sign of trouble. It is difficult for companies to sustain high dividend yields, therefore exceedingly high yields could mean that there is going to be cut in dividends in the future or that the company is in dire financial trouble.Historically, safe dividend yields can range from 1-6%, anything greater should be investigated with caution.

For more information I would recommend borrowing this book from the library. It's a really quick read and gives you the basic foundation for dividend investing. Good luck and keep saving!

Why dividend stocks?


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