Is it possible to live off of dividends?
Can I plan my retirement with dividend as the only source of income?
How much would I need to live off only by stock investing?
Various alternatives or methods are used by an investor to save & generate wealth for living expenses. But true Passive income is one which is generating and growing money while I sleep, limiting investors options to some traditional asset allocation in Fixed income, Real Estate & Equity.
Let us understand stock investing in some basic parameters.
|Low-interest regime enables stocks to generate much higher returns compared to various other asset classes. In the past, only index investing has provided more than 10% annualised returns to an investor in the long run in the form of capital appreciation & also provided regular income in the form of the dividend.
|The stocks of most large & mid-sized companies are highly liquid ensuring capital invested is never locked. Most transactions are settled within 3 days.
Risk of losing the capital is very high, however, such risk can also be faced in other asset classes.
For instance: Risks happen with real estate with poor legal records or default by the borrower.
|Equity investing provides a much higher tax benefit to the investor. The tax benefits are Long term capital gain, Grandfathering & Shorter lock-in period.
|Equity investment is much simpler to its alternatives. It requires less documentation & scrutiny.
|Detail knowledge & skills are required for direct stock investing but by investing in commission-free equity-based mutual funds through Finbingo, such deep knowledge may not be required.
In Equity investing, investors like capital appreciation more than dividend income. As dividend yields are smaller in the range of 2-3%, but capital appreciation is often in double digits. But capital appreciation is always associated with price volatility and high risk. Dividend income is more rational but predicting capital appreciation requires a lot of research & strategy.
What are the dividends income & how does it work?
The term dividend refers to cash payments received for owning shares of equity stock in a company. Investors own a portion of the company making them entitled to a portion of the profits which are paid out in the form of dividend incomes.
Unlike interest payments, dividends paid by the companies are not guaranteed, which increases the risk carried by an investor compared to any fixed-income instrument, but this also creates a great opportunity. Dividend income can be a better source of income, but investors must understand the differences between interest income and dividend income.
Before determining whether dividends are the best option for passive income or as retirement savings, it is important to understand how dividends work. When an investor purchases a stock, they become a part-owner of the company based on the number of shares purchased. Making investors entitled for the profits earned by the company which is shared in the form of dividends. Dividends can be expected by the shareholders as a reward for their trust in a company. The company management may aim to honour this sentiment by delivering a robust track record of dividend payments.
A dividend is paid out on a per-share basis. If an investor owns 100 shares & the company declares a ₹2 per share dividend, the investor receives a total dividend payout of ₹200.
As dividend pay-out is not guaranteed & are based on various parameters such as annual earnings, future guidelines & management decisions which may lead to uncertain income & raise a question –
What’s the magic number for an investor to live off just on dividend income?
Answer – A lot
Initial investment amount needed for Dividend based Income is relatively big, but on the brighter side, there is no limit to how much an investor can earn per annum & the income amount grows on its own. Dividend payout per shares on investments are expected to increase & grow each year resulting in higher dividend income.
Let’s assume your annual expense is ₹12 Lakh & getting a Dividend Yield of 2% is quite easy.
So, at 2% Dividend Yield, you will need ₹6 Crore to get ₹12 Lakh/year
–Don’t get disheartened 🙂 Keep reading 🙂
Dividend payout is always in direct relation to the future cash flow & companies generally increase their dividend payout in value terms each year, which enables an investor to build a stock portfolio with a dividend growth rate of 7%.
Understanding Dividend Yield & Dividend growth
Yield, always expressed as a percentage, is a ratio that shows how much a company pays in the form of the dividend in a year against its current stock prices.
Dividend yield = Dividend / CMP
Growth is the annualised percentage increase in a stocks dividend payout in a particular period.
Dividend growth rate =
[Dividend Year(X) /Dividend Year(X – 1)] – 1
For instance- (Not Recommendation)
As of May 06 July 2020, ITC, an established Tobacco & FMCG manufacturer, had a dividend of ₹10.15 per share & using its current price (25th August 2020) of ₹195.50, its dividend yield would be 5.19%. ITC has announced to provide 80% of its annual profits as dividend payout. This provides high confidence in future dividend growth.
Following are the past dividend payout of ITC:
With that Dividend Growth rate and if investors reinvest Dividend Incomes into the portfolio to buy more stocks, an investor can increase the Yield on Cost faster than 7%. So, Income keeps on increasing each year if the investor holds onto the investment, but that growth rate becomes even faster due to Dividend reinvestment. With dividend re-investments & expected 7% growth rate for the portfolio, one can move from a 2% dividend yield to 3% dividend yield.
–Now see what magic happens with the increasing yield:
Now at 3% Dividend Yield, an investor will need ₹4 Crore to get ₹12 Lakh/ year & at 4% Dividend Yield, an investor will need ₹3 Crore to get ₹12 Lakh/ year
— Doable right? But one must hold onto stocks and let that dividend income increase. With Dividend Growth Investing, an investor doesn’t need to worry about regular market fluctuations. Great businesses maintain or increase dividends even in Recession.
Buy dividend-paying stocks, and hold them for the long term. What is the point about ‘long term’? A stock which is yielding 0.5% at the time of purchase, can yield much higher over time.
For Instance, (Not Recommendation)
- In the CoronaVirus pandemic, ITC declared ₹10.15 per share, rewarding shareholder will 5% dividend yield
○ Suppose a person bought 10 TCS shares at ₹132 per share in March 2009 having a dividend yield of 10.6%. As on 25th august 2020 TCS has paid an interim dividend of ₹28 per share in the calendar year 2020, ensuring dividend yield of 42% in 6 month period
- Note: TCS declared 1:1 share bonus between the year 2009 – 2020
Dividend as Double-edged sword
As an investor, you will be tempted to invest in companies with the highest dividend yields. But Warren Buffett’s company has never paid a dividend. The reason is, instead of paying the dividend they invest the payout amount to generate better returns for the shareholders in the form of capital appreciation.
What if a company pays a dividend even when they have a huge debt that can be paid off instead of paying out the dividend. What should an investor do?
For Instance: (Not recommendation)
- For the year ending March 2020, Larsen & Toubro has declared an equity dividend of Rs 18 per share. At the current share price of Rs 980.40 (25th August 2020), this results in a dividend yield of 1.84%.
- The company has a good dividend track report and has consistently declared dividends for the last 5 years. But instead of paying off the debt, the company pays a good amount of dividend.
- I would ignore such stock for my dividend portfolio
What if a company pays a dividend but at the cost of value destruction? It can provide you with money in your bank account but can also mean a lack of returns.
Following are the example of India’s Highest dividend yield stock: (As on 25th August 2020) (Not recommendation)
|Current share price
|Past 5 Years Absolute return
What’s the Conclusion?
Investing & Holding on to “Strong stocks” for long term (for 10 to 15 years) will ensure its dividend yield will become high enough to beat the returns of any debt instrument and will ensure your lifestyle even after retirement.
Invest in dividend-paying stocks, hold for the long term with patience, and that’s it. The only control point is, one must buy only “good & fundamentally strong stocks“. But how do I identify one? Stay Tuned for answer of this post tomorrow.