Dividends are shares of company profits that are paid out to shareholders and dividend stocks can be an excellent way to earn passive income, in my opinion.
Not all companies pay dividends as some might choose to reinvest profits to grow the business instead. But as I’m trying to earn some passive income, I’d focus on those that regularly pay a decent yield.
What is a good yield?
But what is a decent dividend yield? Well, the FTSE 100 average is currently 3.7%. But the highest-yielding shares offer as much as 13% right now. That sounds mighty high to me, and might not be sustainable for very long.
That’s because dividends aren’t guaranteed. They’re typically paid from company profits. So if the outlook for earnings becomes uncertain, a company may decide to suspend or reduce dividend payments.
This means that instead of focusing on the highest-yielding dividend stocks, I’d look at reliability and affordability too.
For instance, I prefer companies that have consistently been paying cash to shareholders for many years. In addition, I like to see businesses that can comfortably afford dividend payments from their earnings. A common measure to determine this is dividend cover.
I’d say a decent dividend yield is around 5%-8%. There are plenty of UK dividend stocks available in this range right now.
Top FTSE 100 dividend stocks
My favourite FTSE 100 dividend stocks right now include Taylor Wimpey, Imperial Brands, Aviva, Phoenix Group and Vodafone. Each company is from a different industry. That gives me some diversification so I’m not putting all of my eggs in one basket.
Averaged out, my top picks yield 7%, comfortably beating the FTSE 100. They’ve also consistently paid dividends for over 21 years and have an average dividend cover of 1.6.
That’s exactly the kind of reliability and affordability that I like to see.
Were I investing £500 a month in these dividend stocks, I’d split it five ways and buy £100 of each pick every month. That should result in £420 of passive income by the end of the year.
Reinvesting dividends
But instead of spending it straight away, here’s what I would do. I’d use that £420 to buy more dividend stocks. Reinvesting dividends in this way can really boost my performance over time.
To illustrate this point, let’s consider two scenarios. If I didn’t reinvest my dividends, I calculate that after 10 years I’d have a pot that totals £64,200. But if I reinvest the cash every year, after 10 years, I’d have almost £83,000. That’s almost 30% more.
It’s a considerable difference, so it looks like it might be worth deferring the time I start withdrawing the passive income. Of course, this depends on whether I need the income right now or if I’m happy to wait. Personally, I’d rather have a much greater passive income for life and would be happy to be patient.