Covering your expenses with passive income creates true financial independence. When all your expenses are met with income that is not tied to the amount of time you spend creating it in any way, you are free to spend your time however you like.
Work becomes something you do if you want to, not because you have to. True financial independence is difficult to achieve. In my view, the best way to achieve a reliable growing passive income stream that will eventually cover all your expenses is through investing in high quality dividend growth stocks.
The Basics of Dividend Growth Stocks: Dividends
Dividend growth stocks are (as the name implies) stocks that have a history of paying rising dividends. Their dividends are growing.
This creates a powerful effect. Take a stocks like Target (TGT). Target stock currently pays a dividend yield of 4.4%. This means that for every dollar invested in Target, the company is paying out $0.044.
Put another way, shares of Target are currently trading for ~$57, and the company is paying out dividends of $2.40 per year. Target pays its dividend quarterly, so a shareholder of Target would expect $0.60 in dividends per share of Target every quarter.
For a company to pay out a dividend every quarter, it must be profitable (or have a lot of cash in the bank and expect to be profitable soon). In Target’s case, the company is very profitable. In fact, Target has generated $2.73 billion in after-tax profits over the last 12 months on sales of $69 billion.
Investing in dividend stocks means you are (in general) investing in companies that are making money. It sounds like common sense, but it’s very true – invest in companies that make actual money – you will avoid the pitfalls of ‘the next big thing that never was’ investments this way.
The Basics of Dividend Growth Stocks: Growth
The previous section discussed the ‘dividend’ aspect of dividend growth stocks. Dividends create passive income. Taking dividend payments and reinvesting them into the stock that paid them (or other dividend stocks) creates rising dividend income over time.
If Target never increased or decreased its dividend, and you reinvested the company’s 4.4% yield buy purchasing more Target stock, your passive income stream would grow by 4.4% a year while reinvesting dividends.
But Target has a long history of paying rising dividends every year. Target has increased its dividend payments for 45 consecutive years. Think about that for a second… Target has managed to pay its shareholders more in dividends every year for over 4 decades; through bull markets, bear markets, recessions, inflation, and deflation. The company has proven it can reward shareholders in a variety of economic conditions.
Over the last decade Target has increased its dividends at an amazing 18.8% a year. This level of dividend growth is unsustainable for Target. The company managed to grow its earnings-per-share at a more modest 4.6% a year over the last decade.
Dividend growth cannot outpace earnings-per-share growth unless the company raises its payout ratio. The payout ratio is simply the percentage of earnings the company pays out in dividends. At its core, dividend growth is tied to earnings growth.
Now, if Target manages to grow its dividends at just 4.6% a year over the next decade like it did over the last decade, shareholders who reinvest dividends back into Target stock will realize passive income growth of 9.0% a year (4.4% dividend yield + 4.6% dividend growth).
An investment compounding at 9.0% a year will double in about 8 years. This is the power of dividend growth investing – compounding your wealth over time.
Other Great Dividend Growth Stocks
Target is not the only corporation with a long history of paying rising dividends. There is a select group of 51 stocks called the Dividend Aristocrats that are all in the S&P 500 and have paid rising dividends for 25+ consecutive years.
Interestingly, the Dividend Aristocrats Index has outperformed the S&P 500 by over 2 percentage points a year over the last decade – with less volatility.
Target is a Dividend Aristocrat. A few other household name Dividend Aristocrats are listed below:
- AT&T (T)
- 3M (MMM)
- Coca-Cola (KO)
- PepsiCo (PEP)
- Wal-Mart (WMT)
- Exxon Mobil (XOM)
- Procter & Gamble (PG)
- Johnson & Johnson (JNJ)
A portfolio built of high quality dividend growth stocks (like those found in the Dividend Aristocrats List) purchased at fair or better prices is very likely to produce steadily rising dividend income over time.
Final Thoughts on Fair Prices and Diversification
Creating rising passive income from dividend growth stocks means you will have to build a dividend growth stock portfolio. This means investing in many dividend growth stocks.
A portfolio build from 20 to 30 names is likely sufficiently diversified between companies. Diversification is only achieved by diversifying in different industries and sectors. A portfolio comprised of 30 different oil and gas stocks is not diversified, as an example.
In addition to diversification, intelligent investors will also pay attention to value when investing in dividend growth stocks. Buying into great dividend growth stocks when they are trading at lofty price-to-earnings multiples will likely result in poor long-term results. Here’s what Warren Buffett (perhaps the greatest investor of all time) says about when to buy:
“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
It is possible to build a rising passive income stream from dividend growth stocks that will eventually cover (and beyond) your expenses. It takes time, patience, and commitment to let the power of compounding dividend growth work for you – but the end result is more than worth it.