When buying shares to earn a passive income today, I would keep in mind that 2020 has taken a toll on many companies’ financial health. In fact, the pandemic continues to do so.
To me, this says that dividends might have returned but they could be less dependable than before. So, how should I ensure a reliable passive income?
While they are not fool-proof or even comprehensive, the following measures can still get me as close as it gets to a reliable passive income. These are:
#1. Dividend history
Companies with a long legacy of paying dividends are less likely to turn around and stop paying them suddenly. Consider the examples of oil biggies BP and Royal Dutch Shell, both of which have paid dividends for a long time. And both reduced dividends last year.
While that is indeed a disappointment for investors, I think this is still a better outcome than dividend cancellations. Further, I am hopeful that dividends can rise over time, especially this year, given that both oil companies should benefit from high oil prices.
Buying stocks of these oil giants comes with its own challenges, including uninspiring share price trends and a question mark on their long-term futures, but as far as reliable dividends go, they are good stocks for me to buy.
#2. Earnings per share
2020 was a bad year for companies across sectors, so chances are, many otherwise dividend-paying stocks either saw earnings drops or ran into losses. This would show up in the earnings per share (EPS) too.
In less extraordinary times, however, earnings per share, for me, is a good measure of a company’s ability to pay dividends. A company with little or no EPS is unlikely to be able to sustain dividends.
Consider two FTSE 100 stocks with some of the highest dividend yields here – British American Tobacco (7.6%) and Rio Tinto (6.1%). While British American Tobacco has an EPS of £2.8, that for Rio Tinto is at £4.4.
So if I am worried whether they can sustain these high yields, I compare their EPS to that for peers like Imperial Brands and Anglo American. They have EPS numbers of £1.6 and £1.2 respectively. This assures me that both British American Tobacco and Rio Tinto are better placed when it comes to dividends.
Like in the case of oil companies, here too, a high EPS alone is not the only measure to consider. It is just one of them, and from the perspective of passive income generation. The future of British American Tobacco, too, is unknown, for instance. And Rio Tinto has its own set of issues, including the latest one on executive pay.
An additional feature to consider
Related to EPS, I also like to consider the dividend cover, which is the ratio of earnings to dividends. Like in the case of EPS, the higher the cover the better protected my dividends are.
Unlike EPS, which is reported routinely by companies in their financial updates, I find the dividend cover less readily available, however. It is good to have all three to consider, but even the two detailed here help me make passive income investment decisions.
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Manika Premsingh owns shares of BP and Royal Dutch Shell B. The Motley Fool UK has recommended Imperial Brands. 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.