One way I aim to earn passive income is by buying shares that can pay me dividends. But companies pay different amounts – sometimes nothing at all. So, if I had a specific target in mind, how much would I need to invest in dividend stocks?
To answer that question, here is an example where I target £100 each month in income.
The role of dividend yield
The straightforward answer to the question is that my investment level would depend on the average dividend yield of the shares I bought.
Yield is the amount I receive each year in dividends as a percentage of the price I pay for the shares in question. For example, if I spend £100 on shares and receive £7 each year in dividends from them, the yield is 7%.
But a couple of things influence this calculation. First, dividends are never guaranteed. So saying “a 7% yield” presumes the company maintains its current dividend. That may happen. For example, that has been the case at Smith & Nephew in recent years. But a firm could cut its dividend. Or it may raise it, like Cranswick has done annually for over three decades.
The role of share price
A second consideration is that my yield may be different to that of other investors even when owning the same dividend stocks. That is because yield depends on what one pays for the shares.
So if I buy the shares with a £7 annual dividend for £100, I will hopefully yield 7%. But if I wait and the share price goes up to £200, buying then will give me a yield of only 3.5%.
Focus on quality dividend stocks
When buying shares though, I never focus just on the yield. After all, dividends are not guaranteed. A high yield, such as the 18% currently on offer at Persimmon, can sometimes mean investors think a company may struggle to maintain its dividend. In Persimmon’s case, that is because rising interest rates might hurt its sales and profits.
So I focus on finding quality companies with a competitive advantage I think could help set them apart from rivals. That can enable a company to make profits, which can fund the payouts. Only once I have found a company I think has such properties do I then consider its share price – and yield.
Going for a target
If my target is £100 a month in such income, that adds up to £1,200 each year. That would require me to invest £24,000 in dividend stocks with an average yield of 5%, for example. Depending on the average yield of what I buy, I may need more – or less.
But I would not buy what I thought were lower-quality shares just because I wanted to hit a dividend target with a lower budget. Always my focus would be finding quality companies. If I did not have enough funds to hit my income target when investing in their shares, I could lower my target.
Over time, by compounding my dividends, hopefully my funds to invest could grow over the years. That might let me hit my target at some point in future.
