The Motley Fool

How to create a passive income from dividend stocks

Dividend stocks are set to continue to offer a relatively attractive passive income. Low interest rates and the growth prospects of the global economy mean that dividend shares may produce higher income returns than other mainstream assets such as cash and bonds.

As such, building a portfolio filled with income shares could be a shrewd move. Here are some key considerations which could make that process easier, and that may help you to enjoy a robust and growing passive income in the long run.

High and affordable yields

Obtaining high yields from dividend shares can make a major positive impact on your passive income. However, there is little point in buying high-yielding stocks that are unlikely to maintain their current level of payout.

Therefore, it is imperative that you assess a company’s ability to make future dividend payments. This can be done through focusing on its balance sheet strength and calculating the proportion of its net profit that is paid out as a dividend.

Through buying shares in companies with strong balance sheets, in terms of them having modest debt levels, and substantial headroom when making their dividend payments, you may be able to obtain a more resilient passive income.

Track record

The past decade has been a relatively strong period for the world economy and for the stock market. As a result, many companies have found it relatively easy to pay a rising dividend.

However, history shows that recessions and bear markets occur fairly frequently. As such, checking whether a company was able to afford its dividend payments in past periods where its operating environment was more challenging could be a shrewd move.

Mature companies with defensive characteristics may have a stronger track record of paying dividends during difficult economic periods. By contrast, cyclical growth stocks may have less impressive dividend payment histories. By focusing your capital on the former, rather than the latter, you could enjoy a more robust level of income.

Growth potential

As well as considering whether a company’s dividends are affordable, it is a good idea to determine if they can grow. This can be undertaken by analysing the prospects for earnings growth, as well as understanding what a company’s management team intends to do with excess capital. In some cases, they may wish to reinvest it for future growth, or make acquisitions. In other cases, they may seek to pay it to shareholders in the form of a rising dividend.

A company with strong dividend growth may not only offer an increasing passive income. It could produce a rising share price. Investor sentiment towards dividend growth stocks can improve rapidly – especially in an era where interest rates could stay at low levels over the medium term. As such, considering a company’s potential to raise dividends may boost your portfolio’s valuation, as well as your level of income.

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