Generating passive income is often the goal of investing. This can be achieved in a variety of ways, including buying real estate or a small business. But those have very high capital requirements and other associated costs.
When it comes to generating monthly income, we prefer high-quality dividend stocks such as the Dividend Aristocrats.
In this article, we’ll make the case for dividend stocks as a way to generate income, as well as how you can use them to generate $100 of passive income with dividend stocks each month.
Why Dividend Stocks?
In short, dividend stocks are an easy, capital-efficient way to generate income for investors. These are companies that use spare cash to return directly to shareholders, rather than buying back their own stock, making an acquisition, or simply keeping that cash on the balance sheet.
Dividend stocks, therefore, offer investors two ways to compound their wealth.
First, the value of the stock can rise, just like a stock that does not pay dividends. That can create capital gains over time. Second, the dividend stock provides a predictable income stream the investor can use to fund living expenses, or simply buy more stock to generate even more income.
Unlike real assets, dividend stocks can be bought or sold easily each market day, generally for a very low cost. This means that investors can buy dividend stocks with very low capital requirements, and build their position over time. When thinking of alternatives to generate passive income – such as real estate – that’s a huge advantage.
Dividends are generally paid quarterly for most stocks, but some pay monthly as well, so that’s a consideration for the shareholder. Monthly dividend stocks are rare, but can provide additional compounding leverage for the holder over time.
Finally, dividend stocks offer significant liquidity advantages over other forms of passive income, which means the holder can buy or sell quite easily, and in whatever dollar amount suits them.
With real assets, transactions are slow and generally quite costly; dividend stocks don’t have that issue, irrespective of how small or large the transaction amounts are.
That’s a rundown of why we like dividend stocks, but it is also important to remember that not all dividend stocks are created equal. Let’s now take a look at how to find great dividend stocks.
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Picking Great Dividend Stocks
There are thousands of stocks available to any investor today. That amount of choice can be overwhelming, but we do have some tools at our disposal to understand how to find the great ones, and weed out the ones that may be forced to cut their payouts when times are tough.
Within the realm of dividend stocks, there are different kinds of companies with different goals for their dividends.
In other words, there are dividend stocks that want to have a very high current yield, some that want to pay out most of their available cash to shareholders, some that want to have very high rates of dividend growth, and some that are happy to pay a very small amount to shareholders and hold the rest of their cash on the balance sheet.
These different styles all have their advantages and disadvantages, and each investor must determine which is best for them. Is it high levels of current income? Is it great dividend growth characteristics? Is it safe payouts that won’t be cut during recessions?
There are high-quality stocks available for any of these situations, or even a blend of the different types, for investors to choose from. But how do we find the best ones?
Great dividend stocks generally have the same set of characteristics. One characteristic we look for in a great dividend stock is earnings growth. Earnings are generally the basis for any company to pay a dividend, so we want to make sure that the company has the ability to continue to grow its earnings over time.
We do this by ensuring the company first has a track record of doing so, demonstrating it can grow earnings reliably through different parts of the economic cycle.
So long as earnings move higher over time, the company should be able to continue to increase its dividend over time. Companies with reliable earnings growth generally don’t need to cut their dividends either, so this characteristic lends itself to better dividend safety, in addition to the ability to grow the payout.
Companies that are able to do this generally have some sort of durable competitive advantage, and have some measure of recession resistance.
These are key markers of a great company – which then makes for a great dividend stock – and the way that we assess this is through examining the company’s performance during tough times.
Companies with great competitive advantages tend to see small downturns in earnings during recessions, whereas companies with weak or no advantage tend to have outsized negative impacts on their business during recessions.
This generally leads to weak earnings, which can lead to a dividend cut. That’s why we like examining a dividend stock’s performance during recessions, to assess its competitive advantages and likelihood that a dividend cut would be needed during the next recession.
Part of this equation is also the stock’s payout ratio, which is simply the annual per-share dividend divided by the company’s annual earnings-per-share.
This number gives the investor an idea of how safe the payout is, while also taking into account the other variables we’ve already touched on. In general, a higher payout ratio is riskier than a lower payout ratio because that means the margin of safety for things like recessions is low.
As an example, a stock that is paying out 90% of its earnings has very room to grow the dividend, while a stock that pays 20% of its earnings has a huge margin of safety.
Of course, the particular company’s earnings growth rates and recession-resistance come into play, but the payout ratio is a powerful tool in assessing not only dividend safety, but dividend growth potential as well.
By combining the company’s earnings growth potential with the payout ratio, we can assess the company’s ability to raise the payout over time. An example of a low-growth scenario is a company that is growing earnings at 2% annually, and has a 90% payout ratio.
That company is unlikely to be able to raise its payout more than 1% or 2% without undue hardship on its ability to pay because earnings growth is low, and current usage of earnings is very high.
On the other side, a company that is growing earnings at 10% annually and has a 20% payout ratio has an enormous runway for raising the payout. These are some of the variables that investors must weigh when selecting dividend stocks.
Now, let’s take a look at some of the best dividend stocks available in the market today.
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Dividend Aristocrats: The Best of the Best
Dividend stocks are often grouped based upon their consecutive annual dividend increase streaks, with the best of the best in the Dividend Aristocrats. This is a group of stocks that all have consecutive annual dividend increase streaks of at least 25 years, and are components of the S&P 500 index.
That means these companies are all recession resistant to an extent, have durable competitive advantages that have stood the test of time, and are willing and able to return cash to shareholders over time.
In short, Dividend Aristocrats embody many of the characteristics we like in dividend stocks, which is why we favor them over stocks with shorter dividend increase streaks, all else equal.
Unsurprisingly, the list of Dividend Aristocrats is anchored in non-discretionary sectors such as Consumer Staples and Industrials. These sectors tend to have more reliable earnings than retailers or banks, for instance, given their recession resistances is typically higher.
There are only 65 companies out of the 500 in the S&P 500 index that meet this strict set of criteria, which highlights how difficult it is to achieve such a long streak of dividend increases.
Below, we’ll take a look at some examples of great Dividend Aristocrats we think investors should consider to generate passive income.
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Stocks to Generate $100 In Monthly Income
For investors looking to generate $100 in monthly income, the list of Dividend Aristocrats is a great place to start. There are different types of dividend stocks that have made the grade, including high dividend stocks, and high-growth dividend stocks.
We’ll walk through how investors can use both to their advantage when generating passive income.
One Dividend Aristocrat we like for a few reasons is AT&T (T), the century-old telecom operator that is known for its wireless service, as well as its wide and diverse entertainment content portfolio.
AT&T is an example of a stock that has relatively low earnings growth, a relatively high payout ratio, and a low stock valuation, the combination of which creates a sort of bond-equivalent for shareholders.
We estimate AT&T will grow at 3% annually for the foreseeable future, and its current payout ratio is about two-thirds of earnings. With the stock at just ~8 times this year’s earnings estimates, it is quite cheap as well, meaning that the dividend yield is several times that of the broader market at 8.1%.
That’s the sort of yield you’d normally expect from a real estate investment trust, or REIT, not a world-class telecom operator.
AT&T’s dividend growth potential isn’t very high given its growth characteristics, but its payout ratio is sustainable, and with a yield of more than 8%, it’s quite easy to generate meaningful levels of income through ownership.
For instance, if an investor wants to generate $100 per month of income with AT&T, with the current quarterly payout of $0.52, the investor would need about 575 shares, or just under $15,000 worth of AT&T stock.
AT&T pays quarterly, so the dividend of 52 cents per share would be $300 every quarter with 575 shares, or $100 per month, on average.
On the other end of the spectrum in the Dividend Aristocrats is Stanley Black & Decker (SWK), a manufacturer of tools and equipment for professionals and consumers. In contrast with AT&T, this company has high rates of earnings growth, a relatively low yield, and high rates of dividend growth.
In fact, we expect Stanley Black & Decker to grow at 8% annually for the foreseeable future, creating a long runway of potential dividend increases along the way.
The stock’s payout ratio is just 27% on this year’s earnings, so it has significant safety against earnings downturns, as well as nearly limitless room for increases in the coming years. Stanley Black & Decker is a great example of a stock with very high rates of earnings growth and a low payout ratio creating a supercharged dividend growth rate.
The yield is much lower than a stock like AT&T, and Stanley Black & Decker comes in at 1.8%. That’s still well above the S&P 500’s average yield of 1.3%, to be fair. Because the yield is lower, generating $100 in monthly income would require 380 shares at the current payout of 79 cents per share, paid quarterly.
That amounts to just over $68,000 worth of stock to create that income, which is more than four times what is required for AT&T shares to generate the same income.
However, Stanley Black & Decker has enormous room for dividend growth for years to come, so that income stream, we believe, will grow nicely over time. Stocks that already have high yields like AT&T tend to see much less growth.
Investors must choose which kinds of dividend stocks best fit their goals, and pick the best ones based upon that. Or, investors could have a mix of stocks like AT&T and Stanley Black & Decker to get the best of both worlds. As an example, an older investor that is retired may want to focus on high levels of income to fund living expenses.
A young investor with decades until retirement may choose instead to focus on dividend growth names that will raise their payouts for years to come.
Either way, dividend stock investors can compound their wealth over time by carefully choosing the best dividend stocks to fit their needs.
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Investors are faced with an almost overwhelming level of choice when it comes to selecting dividend stocks. However, using some fairly simple criteria, we can determine which dividend stocks are most likely to sustain their earnings during recessions, continue to pay shareholders, and even raise those payouts over time.
There are different styles of dividend stocks available as well, including high-yield and high-growth, and investors can build their dividend portfolio based upon which mix best fits their goals.
We see dividend investing as the best way to compound wealth over time, having many important advantages over other ways to generate passive income.
Generating an income stream of at least $100 per month is achievable for just about any portfolio if built with passive income in mind.