The ‘passive income’ phenomenon has been popular among millennials in the last decade.
Passive income content on social media platforms like YouTube, Instagram and TikTok often attract high levels of traffic and interest. From Shopify Stores, Print on Demand, to even writing Medium stories there are many new ways to try and make some extra cash on the side while sitting at home on your laptop.
But one of the original methods of attaining passive income has been investing in stocks that pay regular dividends. How realistic is it to earn a substantial side income from dividends? Let us now investigate how much you need to be investing to earn €100 per month of dividend income.
But first, why does a company pay out dividends?
When a company makes excess revenue over its costs it makes a profit, at that point the company has two choices. It can either reinvest these profits in the company to try and generate more profits or it can reward its shareholders by paying out these profits in the form of dividends. Long established companies, such as Coca Cola for example, who are in mature industries often pay out a large portion of their profits as dividends. This is because they are generating cash well over what is needed to fund the current business growth. The current Trailing Twelve Month (TTM) payout ratio is 78% for Coca Cola (KO). Meaning that for $100 of profits the company makes, $78 is paid out to shareholders and $22 is reinvested in the company.
What is a dividend yield?
The dividend yield is an important concept to understand when it comes to dividend investing. We will be using the dividend yield formula later to work out how much we need to invest to achieve our target monthly dividend income.
Put simply the dividend yield is the annual dividend amount divided by the current share price of the company. If we continue to use Coca Cola for our example, Coca Cola currently has a share price of $59.21, the last annualized dividend that was paid out amounted to $1.68. This gives the company a current dividend yield 2.84% ($1.68/$59.21*100).
The dividend yield will vary from company to company, a higher dividend yield will mean that you will receive more dividend income per $100 you invest. IBM for example have a dividend policy that aims to pay out at a dividend yield of roughly 5% , therefore $100 invested in IBM should return a dividend of $5 per year. A high dividend yield is not always a good sign however, as it may be the case that the company is returning too much to shareholders at the detriment to the future success of the company.
How can we use the dividend yield to work out the amount we need to invest to earn an average of €100 p/m dividend income?
We can use the dividend yield formula to work out how much we need to invest to earn €100 by turning the formula on its head.
As seen in the working above an investment of €24,000 is needed in IBM stock to generate a dividend income of €100 p/m. This is quite a considerable amount of capital to invest and we still have not included the effect of taxation.
Taxation needs to be then factored in to work out the net amount that is receivable which will further suppress the returns.
When you earn dividend income in Ireland you are taxed at your income tax rates (PAYE, USC, & PRSI). Therefore, if you earn €1,000 it will be taxed at your marginal tax rate, which is the rate of tax you pay for each additional euro you earn on top of your regular salary.
If you are on an average salary of €40k per annum your marginal tax rate can be as high as 52%. Lets now build this in to our example.
When we factor in taxes, this increases the amount of money needed to be invested in IBM to receive €100 p/m dividend income (after tax) to €50,000.
This may be worthwhile for some but may not lead to an adequate return for others. Dividend investing has gone out of fashion with retail investors in favor of hyper-growth stocks such as Tesla and GameStop. But dividend investing can be a useful tool for those who have already made significant growth in their capital and are now looking for a stable vehicle to earn periodic income.