Dividend stocks can be a great source of passive income for an investor like myself. However, the passive part of the investment comes once I’ve bought the shares. In order to enjoy the dividends in the future, I do need to put in some work at the beginning to make the best use of my money. Here are some ways I’m finding and investing in cheap dividend stocks.
Taking advantage of share price dips
The first way I’m using cheap stocks is hunting for high dividend yields. The dividend yield is an easy way of comparing stocks that pay out income. It compares the last dividend per share to the current share price. If the dividend per share stays the same but the share price falls, the dividend yield will increase.
So if a stock has fallen recently, the dividend yield will have likely increased. This move might now make the stock cheap, and I can take advantage. Buying the shares at the lower price means that I can lock in the yield.
However, I do need to be careful, as the share price might have fallen for a valid reason that might cause the dividend to be cut in the future.
Aiming for passive capital gains
Another way I’m using undervalued stocks for passive income is via potential share price gains. Most of the time we think of passive income coming simply from the dividend payments. However, if the share price rallies during the period I own it, this profit from my capital is also passive in nature.
Therefore, I can eye up companies with a low price-to-earnings ratio. This could indicate that the stock is cheap. If I combine this also with those paying out some form of dividend, I could benefit on both sides.
A couple of examples in the FTSE 100 include Barratt Developments and Kingfisher. These both have P/E ratios below 10, which is cheap by my standards. Both also pay out respectable dividends.
Protecting my passive income
I also want to use cheap stocks not only to enhance my passive income, but also to protect it. After all, there’s no point in picking up dividends for years, only to realise that the stock price has fallen over my holding period. In this case, my capital loss could exceed all of the income I’ve received over the years.
Although it’s impossible to completely protect against this, buying undervalued stocks should help to reduce this risk. Even though a company can be over/undervalued in the short run, usually in the long term it returns to a fair value.
For example, the Barclays share price is down 21% over the past year. I think this is below the fair value and so feel my risk of further capital depreciation is limited. This would make it an attractive buy from my point of view, with the 4.1% dividend yield on offer.
Finding as much value as possible
There are many ways that I can go about selecting stocks for passive income. I think that using ‘cheap’ stocks is one of the smartest ways. It can help me to take advantage of higher dividend yields and also can offer me potential long-term passive share price gains.
