Investing in Dividend Stocks for Passive Income – Benefits and How to

Dividends are one of the fastest ways to grow your earnings. Let us learn how investing in dividend stock for passive income works.
Dividend stock as passive income

When it comes to stocks you have all kinds. There are stocks that promptly pay out dividends that are better than FD returns. Then there are stocks that reinvest the dividend instead of paying it to stockholders which in turn increases the value of the stock. Today, as someone searching for different avenues of passive income, let’s explore the benefits of investing in dividend stocks for passive income.

In today’s world, everyone is striving to increase their financial income. Here is where passive income comes to play which is investing in dividend stocks. You reap the benefit of dividend income after putting in some upfront time to make your investment decision. Earlier we saw what is passive income and various types of passive income, here I am going to take you through the idea of buying dividend stock to earn passive income.

What is Dividend?

When a company needs money, the owners sell a partial stake in the companies to outsiders in the form of stocks. The money thus collected is used to scale the company. When the company makes excess profits, the money that is remaining after expenses and future growth plans are funded can be paid to investors.

This distribution of some of a company’s earnings to its shareholders is called dividend. Dividends can be issued as cash, the share of stocks (bonus or rights), and other property(in kind). Not just companies, various mutual funds and exchange-traded funds also pay dividends in the form of cash, additional units or bonus.

Stock dividends such as bonus shares or rights issues are mainly given when a company does want to reward its investors but doesn’t have the spare cash. A stock dividend has a tax advantage for the investor.  It can provide investors with predictable income as well as long-term growth potential.

Why invest in Dividend Stock?

No doubt, dividend investing is the easiest passive income source you can start off with. Unlike real estate investments that provide passive income, buying dividend providing shares are far easier. You can do it all from the palm of your hand; with your smartphone. The target is always financial freedom.

You are also a minority owner in a business and maintain no controlling-interest decision-making. Here I have listed some important reasons why dividend is considered one of the best investments.

Low cost

Companies such as Zerodha have bought down trading fees to ultra low figures. Unlike properties or other passive income channels such as side hustles, buying stocks takes a couple of minutes (selecting which to buy is going to take a lot longer!). There are no stamp duties, registrations, maintenance and hassels.

Fractional Share

Some companies have introduced fractional share investing. If you are thinking of investing abroad, you can do so with as little as $1.00. Popularized by Robinhood, this is all the rage right now. Of course, you will also get a dividend that is in proportion to your holdings.

Dividend Reinvestment

The dividend reinvestment gives you the opportunity to reinvest your dividends to continue to grow that income stream by acquiring more shares. With discipline, you will have a considerably large investment portfolio over a period of time.

Dividend Taxation

Dividends received preferential tax treatment. With recent taxation changes, dividends are no longer taxed by the company. You need to pay tax on it separately. This can be advantageous for those in the lower income brackets.

If the dividend you receive is over Rs.5000 from a particular stock in the instance, then a 10% TDS (20% if you have not furnished your PAN details) is deducted which you can claim back later when filing your taxes.

How to invest in dividend stocks?

Here are a few things you need to keep in mind before investing in dividend stocks.

Earning growth

When searching for a dividend stock to invest in the long-term, always focus on the stability of the company. Erratic revenue and all-over-the-board earnings might create trouble in the future. It is low cost and you also get the advantage of instant diversification. 

Past records

A company that has a record of raising its dividend every year is worth investing in, especially during hard times like recessions and pandemics. Also keep an eye on their record of their management, like their current CEO and other staff. 

Payout ratio

A reasonably low payout ratio is a good sign that dividend is sustainable. A payout ratio is the proportion of earnings paid out as dividends to shareholders.

Business Model

It is crucial to understand the business model of the company you are investing in. You need to look around for significant points which the particular company has over others.

Dividend Stocks vs.Funds

Dividend ETFs or index fund gives investors access to a selection of dividend stocks within a single investment. In just one transaction, you can have a portfolio of dividend stocks. A dividend fund offers the benefit of instant diversification. You can always rely on income from the others in case one stock held by the fund cuts or suspended.

Although investing in dividend stocks requires a lot of hard work on the part of investors such as researching whether each stock can be relied upon for your overall portfolio. But the investor can choose individual dividend stocks where they can build a custom portfolio that may offer a higher yield than funds. Expenses are also low with dividend stocks, as ETF and index funds charge an annual fee, called an expense ratio.

Dividend Aristocrats

In the US, the Dividend Aristocrat Index is a collection of several companies maintained by the S&P  500 that have increased their dividends for at least 25 consecutive years. Every company in the index successfully gave investors raises not just during the good times in the market, but also during volatile downturns. Index as a whole can offer more diversification than high-yield dividend indexes. It is considered safer investments than the average dividend-paying stocks. 

For companies to get listed in Dividend Aristocrat they must have:

  • Increased dividends every year for the last 25 years.
  • A float-adjusted market cap of at least $3 billion.
  • An average daily trading value of at least $5 million.

While the Indian market does not have a Dividend Aristocrat alternative, brokers such as Zerodha provide tracking mechanisms that allow you to filter out Indian stocks that fall within this rule. Let us now take a look at some of the best dividend stocks for passive income:

BAJAJ AUTO LTD.

Bajaj Auto is by far India’s largest motorcycle and 3-wheeler exporter. What distinguishes Baja from other 2-wheeler companies is that it is focused more on the market outside of India. The company has a high dividend-paying stock with a payout ratio of 67% in FY20 and provides a dividend yield of 4%.

GAIL

GAIL has the dominant position in the natural gas transmission business with a market share of 70%. This company focuses on increasing the share of natural gas in the overall energy mix of the country to 15.0% from 6.5%. This has also diversified into downstream sectors i.e. manufacturing of petrochemicals and liquified petroleum gas (LPG). The company has constantly maintained a dividend payout ratio over 25%  that is considered not that high, but its excellent superior dividend yield currently at 5.12% shows including GAIL in the model portfolio is a great dividend stock.

ITC Ltd

ITC Ltd started as a cigarette manufacturing company with brands like Goldflake, Flake, and Classic under its banner. It has expanded into stationary and educational products, packaging, and paperboards, among others. For FY20, the consolidated operating margin was 39%. Liquidity was strong because of cash and liquid investments. Over the past few years, the company has maintained a dividend payout of over 50%, currently yielding to 5.20%.

Even the most rock-solid dividend stock can experience significant volatility over short periods. The company listed above should make great long-term dividend investments, don’t worry too much about day-to-day price movement. Instead, try to find companies with excellent business and strong dividend track records, and the long-term will take care of itself.

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Moumita D

Moumita is a finance savvy engineering grad who loves exploring and writing about all things finance and tech.

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