Dividends are an incredible income source and are a simple way to make a regular passive income. Or they can also be used as a way to grow wealth and get rich over time through compounding. In this post we will explore these 2 ways in which you can get rich with dividend income.
What Is Dividend Income?
Dividends are a reward payment made to shareholders from a company’s earnings. In order to receive dividend income, you must own stocks or mutual funds that pay a dividend. Most companies pay cash dividends. But there are several alternative types of dividends a company can pay.
There are many different categories that stocks can be classified as such as income stocks, growth stocks etc. Some stocks do not pay a dividend at all, or only pay a small dividend.
Dividend stocks are usually well established businesses with a long track record of paying dividends. They often have stable and reliable earnings that can be regularly distributed to shareholders.
Dividend investing is a long term investment. It does offer investors two different options – regular income or long term capital growth. Cash from dividends can form a regular source of recurring income. Or they can be re-invested for future growth through compounding dividends. We will explain both of these further in the article.
Which Stocks Are Good For Dividend Income?
Whilst we cannot recommend any individual stock as an investment, we will list a few things below to look out for when researching dividend stocks. Stocks found in sectors like consumer staples, utilities and real estate tend to offer some of the highest yields.
It is up to the individual to decide if an investment is suitable for them. If you are unsure, consult the services of a professional.
A dividend yield is the ratio of dividends in relation to the current share price. Divide the total annual dividend by the current share price to calculate. It is how much of your investment you would earn back as a dividend, expressed as a percentage.
So if a stock’s current price is $100 and it pays a dividend of $10, it’s yield would be 10%. So if you invested at this price you would earn a 10% return.
Dividend yields use the previous year’s dividend payment as a percentage of the current share price. So it isn’t always 100% accurate but is a good indication of what it pays. A dividend may be raised, reduced or cut completely.
Whilst a higher yield means a bigger return it doesn’t always mean it’s better. Very high yields are often as a result of falling share prices and can indicate wider problems with the business. Although this is not always the case. Assess the yield in conjunction with the other points on this list to give a better overall assessment.
The payout ratio shows the percentage of a company’s earnings that are going towards dividend payments. Some companies may have a ratio of over 100%. This is not healthy as it indicates the company is paying more dividends than it’s income. Meaning it either has to borrow money to fund the dividend or make a reduction to the dividend.
Look for companies that have a good history of stable and growing dividends. A company that has consistently raised it’s dividend for many years even during poor economic cycles is a positive sign.
Companies with a history of solid and stable revenues year after year are much more likely to continue to generate enough cash to keep paying a dividend. Those companies with erratic earnings are more susceptible to dividend cuts.
Use Dividend Income As A Regular Income Source
Dividend payments are a form of passive income. Passive income is a source of income that requires little to no active intervention to make money. It literally means you can earn money while you sleep. Of course you do need to spend time researching stocks first. But after making your initial investment, it can be left to work to automatically produce an income.
Dividends are a good option for anybody requiring a regular income. This may be to supplement wages or other investment income.
Dividend payment schedules vary from company to company. For instance, some may distribute them annually or bi-annually, others may be quarterly. Some even distribute monthly dividends. By investing in a variety of dividend paying stocks or funds you can structure your portfolio in a way that ensures a regular flow of dividends.
In addition to dividend income, you may also benefit from capital growth of the stocks you hold. This is the increase in a company stock price.
Compounding Dividends Income By Re-Investing
Those that don’t require the cash from dividends to be used as income can instead use it to their advantage to get rich slowly. This is done by simply re-investing the dividend income back into more of the same stock. It can help grow wealth through the compounding effect.
You may be familiar with compound interest – this is interest paid on the principal amount and on the interest. It allows the initial deposit to grow substantially over a long period of time as each interest payment in turn earns interest. If you hold a cash savings account with a bank then you are earning compound interest.
Well compounding dividends works in much the same way. Only instead of earning interest on interest you earn dividends on dividends.
Each time you re-invest a dividend payment into the same stock you now own more of that stock. This means you will earn a higher dividend payment the next time they are distributed as you own more of the stock. Re-invest this to own even more stock and in turn receive more dividends.
The longer this cycle continues the more wealth you will start to accumulate. Compounding provides a snowball effect the longer it runs. It has the potential to return many multiples of the original investment if left for a long time frame. Which is why we refer to it as a proven way to get rich slowly.
Dividend Income Compounding Example
Let’s take a look at an example of dividend income compounding to demonstrate how it works.
Suppose you have performed research into dividend stocks and have found a stable dividend payer. You decide to invest $10,000 in to this company whose stock price is currently $100. Your $10,000 buys you 100 shares. It currently pays an annual dividend of $5, giving a dividend yield of 5%.
You receive a total of $500 in annual dividends. If you elect to receive this as a regular income then you can withdraw the cash and do with it as you like. But let’s assume you want to re-invest it.
The share price is still $100, therefore your $500 dividend purchases you 5 extra shares in the company. So you know own a total of 105 shares worth $10,500.
The next annual dividend is distributed again. It remains consistent at $5 per share again. If you did not re-invest the previous dividend the you will again only receive $500 as you still own only 100 shares.
But going back to our re-investment example where we own 105 shares. This now receives us $525 in dividend income. When re-invested this brings our total return so far to $11,025.
Can you see already even after only a couple of years how the compounding effect is starting to take shape?
Even if over the years there is no stock price or dividend growth and the stock price is still $100 and the dividend is still $5 per share, we would still make a solid return. After 15 years of re-investing these dividends our total shareholding would now be worth over $20,000. That’s more than double our initial investment of $10,000. And you didn’t have to do anything to work for it.
Factors That Affect Compounding Dividends
The above is just a very basic example to demonstrate how compounding works and doesn’t factor in changing share prices, taxes etc.
However real life situations will be more complex and there are a number of factors that affect returns, either positively or negatively. These include;
- The stock price fluctuation.
- Increase or decrease in the dividend.
- Dividend distribution and re-investment frequency.
- Whether you make any additional one-off or regular investments.
- Trading fees.
- Length of time you hold the investment for.
In an ideal situation the combination of consistent dividend increases, rising share price and a long time horizon are what will result in huge growth.
What Other Income Can Compound?
Whilst we are focusing more on stock dividend income in this article, any type of investment income can compound if re-invested. This includes royalty income and interest income.
Stocks and mutual funds that pay dividends will compound when re-invested. Some types of investment may only produce simple interest, for instance bonds and P2P loans. However, re-investing the income they produce into the same asset has the potential to compound. If you elect to take the payments as an income then the asset cannot compound.
Some examples of common investment assets that can compound when re-invested;
- Stock and mutual fund dividends
- Cash savings accounts
- Peer to Peer loans
- Royalty income
- Rental income (REITs)
Learn more in this blog post about the different types of interest and the power of compounding.
Compounding Dividends Income Conclusion
Dividends are paid to shareholders of stocks and mutual funds. They are a great passive income source that presents investors with 2 options. Either elect to take the cash as a regular income. Or re-invest it back into the stock.
If you don’t require the cash in the short term then re-investing is the best option to help you get rich slowly. By re-investing dividends you purchase more shares and in return receive more dividends. This cycle keeps repeating to grow your investment and is known as compounding dividends.
Whatever an investor decides to do with the cash, dividend income is a great source of passive income. Time is required to research suitable investments, plus the capital to purchase the assets. But once invested it is a very hands off income stream. Dividends are paid out automatically. Most trading and investing platforms including micro investing apps allow automatic re-investment of dividends. So you do not need to do anything. Although it’s always prudent to check in and re-evaluate your portfolio from time to time.
Find more essential reading on our blog including;
- Why you need multiple sources of income.
- Alternative investments to diversify a portfolio.
- What are shares?
Please join our newsletter to keep up to date with all our latest personal finance content.