How to earn passive income through the power of dividend investing

Karl 9th Jun 2023 No Comments

Reading Time: 4 minutes

Pile your wealth into stocks that pay dividends and you could be setting up a nice little passive income stream for yourself.

In this article, we’re going to explore the ins and outs of dividends. Plus, we highlight how you can find stocks that make regular payments to shareholders, and explore the two popular dividend investing strategies. Keep reading for all the details or click on a link below to jump straight to a specific section…

What is dividend investing?

A dividend is a payment made by a company to its shareholders and is usually paid on a quarterly or annual basis. The payment may be in cash, or in the form of additional equity.

It’s worth knowing that firms issuing dividends are essentially sharing a slice of their profits with investors. This is why the size of dividends can differ from one year to the next. However, not all companies closely align their dividend payments with the size of their profits. Firms may still issue generous payments to investors even after a bad year and if they do, this is likely to increase their ‘dividend yield’.

Now we’ve touched on what dividends are, you probably won’t be surprised to learn that ‘dividend investing’ simply refers to an investing style where investors buy stocks according to their dividend potential.

Dividend investing strategies

There are essentially two dividend investing strategies: A ‘Dividend Growth’ strategy and a ‘Dividend Yield’ strategy.

Let’s take a closer look…

A Dividend Growth strategy is where investors seek to put their money in companies still in their development stage. In other words, these investors are looking for firms that have demonstrated stable growth and rising profits year after year. While not always the case, companies ‘on the up’ are decent candidates for being able to steadily increase their dividend payments over time.
A Dividend Yield strategy is where investors take note of one thing – dividend yields. A dividend yield refers to the percentage of a company’s share price that it pays out in dividends each year. So, if a firm’s share price is £100 and pays £2 per share in annual dividends, its dividend yield is 2%.

Why don’t all companies pay dividends?

Not all companies pay dividends. Amazon famously doesn’t issue regular payments to shareholders while other big-name companies in this boat include Apple, Alphabet, Meta, Boeing, Airbus, and Exxon Mobil – and there are many more too!

A good number of firms shun dividends simply because they aren’t profitable. After all, without profits, where would the money come from? However, for companies that are profitable, the decision to withhold payments to shareholders is simply a strategic one.

Often, companies that don’t pay dividends prefer to re-invest their profits back into the business. The reasoning behind this is that investors will (hopefully) see higher, and faster capital growth, as opposed to earning a short-term dollar or two. Withholding dividends may also be tax-efficient.

As an added boon, refusing the temptation to issue dividends might be looked upon favorability by non-market stakeholders, such as employees.

Imagine you’re told by your employer: “Sorry, we can’t give you a pay rise this year, we don’t have the budget.”

And then you discover your employer has been making hefty dividend payments to shareholders.

It’s likely you wouldn’t be too pleased.

A firm that doesn’t pay dividends to shareholders is able to side-step this delicate issue.

Yet, while withholding dividends does have its benefits to business, there’s another side to this coin of course. Let’s not forget the opportunity to earn dividends can attract investors in the first place. So if a firm cuts back on making regular payments to shareholders, or stops paying dividends altogether, it’s easy to see how this could lead to an outflow of capital.

How to find stocks paying dividends

If you’re interested in dividend investing and earning a passive income, here are three tips to find the right stocks for you.

1. Find firms with a history of paying dividends

Dividends are rarely guaranteed but if you invest in firms that are profitable and have consistently paid out dividends to shareholders then it’s likely you’re onto a winner.

2. Nail down your dividend investing strategy

If you’re keen to invest and earn a share of the spoils then it’s important to get to grips with your preferred dividend investing strategy. For example, if you’re a ‘growth dividend’ investor you’ll need to identity firms in future-proof sectors that have a decent chance of increasing their profitability over time.

If going down the ‘yield dividend’ route however, you’ll need to compare a company’s profits against its dividend payments. Just be mindful that a high dividend yield isn’t the be-all-and-end-all. In fact, if a dividend yield is too high, there’s a chance it simply isn’t sustainable in the long-run. This is why yield dividend investors may wish to prioritise firms with dividend-payout ratio less than 60% to 70%.

3. Choose firms with high pricing power

Because dividends are closely linked to profits, investing in firms that specialise in goods with inelastic demand could be an astute move. In other words, if a firm has high pricing power then demand for its goods or services are less likely to be impacted by any external factors. This is why investing in firms with high pricing power could be a nifty way to boost your chances of earning healthy dividends.

While there’s no set definition of firms with high pricing power, companies involved in utilities, prescription drugs, and groceries are some decent examples.

Are you looking to invest in dividend stocks? Take a look at our article that explains how to buy shares. And don’t forget… you can hold dividend stocks in a stocks and shares ISA.

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Disclaimer: When investing your capital is at risk. Remember, the value of any investment can both rise and fall. Always do your own research.

MoneyMagpie is not a licensed financial advisor. Information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.