Saturday, January 26, 2008

What’s a passive income from dividends?

Among the popular internet media there’s a widespread belief that passive income is income which you receive without even moving a finger. Although the term passive income implies that you simply receive checks or that the money is simply directly deposited into your bank account without any effort on your side, I think that that’s not the case in reality. An example of passive income that comes to mind is interest on Bonds that is paid to the holder at a fixed period. Other examples include royalties from music sales, which was created by artists long after their bands have fallen off the charts, income from rental properties, income from online advertising and income from dividends.
From these examples it is visible that passive income is a direct result of some economic activity or work, which created some good/service which society is still willing to reward the holder of the idea long into the future. If you buy stock in a corporation, you increase the liquidity of its shares, making it easier for the company to sell stock in the future to its shareholders. This liquidity also provides an incentive to shareholders to keep their wealth invested in stocks, because they would always be able to transform their paper wealth into dollars and consumption. Investors are further rewarded for holding stocks which reward them with dividend payments paid 4 times per year in the US. Some foreign corporations though, pay their dividends once a year, which provides an uneven stream of income for their shareholders, unlike US ones.
Studies have shown that dividend paying companies tend to outperform the general market over time. Thus I believe that a strategy of investing in stocks that regularly distribute their earnings to shareholders will provide one with a good return over time. Companies that pay dividends show that they care about their owners and have a good corporate policy toward them. Companies that not only pay dividends every year, but also strive at increasing them every year show confidence in the superiority of their business model relative to other industries. An investor, who puts his money to work in such a stock, will be rewarded with an ever increasing stream of income, which would compound at faster rates than simply putting ones money in a bank account.
Thus I believe that building a well-diversified portfolio of companies who have a history of consistently increasing their dividends over time is a good extra source of income for many people. It takes very little time to set up and implement, and can lead to very good returns in the future by reinvesting and compounding your dividends and spreading your buys over time.
I have attached a chart showing the dividend payments over time for Pepsi Co since 1977. If you had invested $1,000 back in those days into Pepsi Stock, your annual dividend income would have risen from $34 during your first year as a shareholder to $1071 in 2007. Furthermore, if you had simply reinvested these dividends every year, your initial $1000 investment would have grown to over $116,000. The main reason for this high number is dividend reinvestment - if you had spent your dividend payments each year instead of reinvesting them into company stock your investment would have been worth only $51,000. In addition, if you had kept on reinvesting your quarterly dividend payments, your annual income would have increased to over $2,000 in 2007. Of course this sort of capital gains might not be replicated in the future but one thing is for sure – if the company keeps expanding and raising its dividend payment year in and year out, I would be its stockholder. It’s very nice to have your salary increased every year. That’s what dividend aristocrats like Pepsi provide to their shareholders in terms of payments.

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