Investing in stocks and shares can be a great source of extra income. Sometimes, though, the best opportunities aren’t always the most obvious.
The FTSE 100 has stocks with 8%, 9%, and 10% dividend yields. But to try and earn passive income for the long term, I’d look to take a different approach.
Dividend growth
For investors looking for stocks to buy, there are two things that matter. One is how much cash a company can distribute to its shareholders and the other is how much its shares cost to buy.
The big question, though, isn’t how much cash a company can pay out today. It’s how much it is going to be able to pay in dividends over the long term.
A stock with a dividend yield of 10% might look like good value. But if its payments are going to stop (or drop) after five years, it’s not going to be a good source of income 25 years from now.
By contrast, a stock offering a 2% yield that is going to be able to increase its distributions over the next two decades is eventually going to pay out more.
Diageo
FTSE 100 drinks company Diageo (LSE:DGE) is a good example. At today’s prices, the stock comes with a dividend yield of 2.7%, but there’s reason to think this can grow over time.
Over the last 10 years, the company has grown its dividend per share by an average of 4.5% each year. And I think the chances of this continuing are pretty good.
While any company has cyclical ups and downs, Diageo looks set to benefit from a long-term trend towards premium beverages. This should help push sales higher.
On top of that, the firm has been buying back shares at a rate of 1% per year. So the business doesn’t need much in terms of growth to maintain its rate of dividend increases.
Risks
Diageo has been a strong performer for investors to date and I think the outlook for the business is fairly bright. But investing in stocks always comes with risks.
One of these is inflation, which has been high recently. Higher input costs have caused the firm’s operating margins to contract from 31% in 2019 to 27% in 2023.
Investors should keep an eye on the situation here, but the longer-term situation looks more promising. Despite the recent fall, Diageo’s margins are still in line with their 10-year average.
The company’s strong brands should allow it to do well as long as inflation doesn’t get worse. And with interest rates in the UK and the US staying high, there’s reason to be positive.
Investing £10,000
At today’s prices, £10,000 buys 339 shares in Diageo. And with the company paying out 82p in dividends per share over the last 12 months, that’s £276 in passive income for the year.
That’s a long way short of £73 per month. But the company increasing its payments by an average of 4.5% each year is enough to bring it to that level within 25 years.
My plan with dividend stocks is to find the best companies I can and let them grow. Over time, I expect this to produce better results than looking for a big yield straight away.
