This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
When you're building an income stream with dividend stocks, not all that glitters is gold. Some companies might appear to offer far more juicy payouts to investors than they actually do on a regular basis thanks to special dividends or intermittent ones, and others might be disbursing unsustainably high amounts of cash.
If you want your passive income to be as close to fully passive as possible, you'll need to figure out how to sift out the companies that can actually continue to keep paying you quarter after quarter. So without further ado, here are three secrets that'll help your passive-income investments to be as lucrative and long-lived as possible.
1. Yield is a poor metric
The most important thing that every passive income investor should know is that dividend yield isn't a metric you need to obsess over. Take Abbott Laboratories (NYSE: ABT) for example; its forward dividend yield is just over 1.8%, and it's a member of the high-flying crew of companies known as Dividend Kings that have increased their dividend payments annually for 50 years and running. Look at this chart:
ABT total return level. Data by YCharts.
As you can see, Abbott's yield has fallen over the last five years while its dividend payments and its total return have risen. Buying shares five years ago was a great investment, even if the yield dropped, as the yield's fall was a result of the stock's price rising.
And the amount of passive income disbursed per share only went up during that period. So if you saw its relatively low forward yield today and then noticed that the yield fell, don't interpret that as a problem, because it isn't.
Remember, the yield is just a measurement of how much of a single share of the stock you could buy with a year's worth of dividend payments in hand. Rising yields can be caused by a plummeting stock price, so treat them with suspicion.
2. Growth wins the day
Companies that grow their cash flows consistently over time are better passive-income stocks than those that don't. And to grow regardless of the economic environment du jour, it's necessary to have an effective business model that's both adequately diversified and profitable. After all, accumulating passive income is a long game, and it's a lot harder to win when your portfolio companies hit major setbacks from which they can't easily recover.
Making a few different types of evergreen products means that unexpected stumbles in one revenue segment are unlikely to spill over into others, and it also means that investors are less likely to pick up the tab for problems in the form of a dividend cut.
Let's look at Abbott Labs once again:
ABT revenue (quarterly). Data by YCharts.
Abbott had no problem expanding its revenue, net income, free cash flow (FCF), and its dividend over the past five years. To accomplish that growth, it sold many of the same products that it always has: branded generic medicines, clinical diagnostics, stents and pumps for heart surgery, and baby formula, to name a few.
It also worked to develop better versions of its existing products, such as its FreeStyle Libre 2 glucose monitors, not to mention making new products altogether, like its BinaxNOW coronavirus rapid diagnostic tests. And both of those two are among the leaders in their markets.
It's true that developing new products is risky, and it can be expensive, too. But without an engine of growth, investors can't expect businesses to keep hiking their dividends, and that somewhat caps the amount of income you can make by investing in them.
3. Patience is a virtue and so is reinvestment
The last secret is that setting up a dividend reinvestment plan (DRIP) is a good idea if you think that you'll want more passive income in the future than you could get from a dividend stock today. When you reinvest your dividends into buying more shares of a company, you're banking on the slow process of compounding to work in your favor over time. If you just spend your dividend income immediately, you won't get the benefit of what might well be decades of compound growth.
At the same time, you don't need to let your investment compound in value from the reinvestment of its dividends alone, and it's often a good strategy to increase your holdings with additional share purchases over time. The more patient you're willing to be, the more likely it is that you'll have a chance to buy shares when their yield is high relative to the level at which you first invested.
And the more you're willing to keep investing over time, the larger your income stream will be whenever you decide to stop reinvesting and start accepting quarterly cash infusions into your bank account.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
