Passive income from dividend shares can generate a surprisingly significant amount of money over the long term. So much so, that you might reach a point where you no longer need a job.
But investing in the stock market is certainly not without risk. The 2020 market crash demonstrated this, with over 500 UK stocks cutting or suspending dividend payments. And with the market still not fully recovered, there are still many undervalued high-yielding, high-quality stocks.
Earning reliable passive income from dividend shares
In order to retire early, passive income from dividends needs to be reliable. After all, there’s no point investing capital in a stock with a high yield if the payments will be cut later on. This is commonly referred to as a ‘yield trap’.
Over the years, I’ve found that stocks with a yield higher than 6% typically not sustainable. However, that is not always the case. Finding stocks that pay large sustainable dividends is the key to generating enormous passive income. As such, there are three simple checks I use to identify a yield trap.
The first is looking at the level of debt. Is the debt-to-equity ratio higher than 2? Interest fees on debt have a higher priority than dividends. Therefore, a highly leveraged firm may cut dividends during periods of poor performance to keep up with interest payments.
Next, I look at the dividend proportion of total profits. If a stock pays out most of its income as dividends (or worse still, borrows to fund the dividend), then there isn’t much left to invest and grow.
The final check is looking at the business itself. Are there any major problems that can’t be resolved within a year? If so, then a dividend cut might be approaching.
Using dividends to increase your dividends
Most brokers and share-dealing accounts have the option for automatic dividend reinvestment. Simply put, whenever I receive dividends from a stock, the cash is automatically used to buy more shares of the same company. This unlocks the best investing weapon – compounding.
By using dividends to buy more shares, the next time a payment is made, the amount I receive is higher as I now own more shares than before. Also, an increased frequency in dividend payments further accelerates the effects of compounding. Therefore, I like to buy shares that pay dividends quarterly.
A top dividend share I’d buy today
Anglo Pacific is a royalty-based mining company that I hold in my own portfolio, whose business model I’ve previously explored.
It has a dividend yield of 7% at its current share price — a potential yield trap. But a closer look reveals it has only a minor amount of debt and around half of its profits are retained to grow the business. And while there were Covid-related disruptions in the first half of 2020, most of them have now been resolved. It even increased its dividends in 2020, while other mining companies, like Glencore, cancelled them.
In my eyes, the stock looks undervalued. And with dividend payments made every quarter, Anglo Pacific looks like a great source of passive income.
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Zaven Boyrazian owns shares in Anglo Pacific Group. The Motley Fool UK has recommended Anglo Pacific. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.