Among the buzzwords you hear a great deal when you read about finance and investing is “passive income.” One way that you can earn money passively in a regular income stream is to invest in dividend-paying companies. These are companies that regularly pay out a portion of their profits to shareholders, called dividends. “Dividend” is derived from the Latin “dividendum”, which indicates something that is divided. In truth, in ancient times it probably meant spoils of war or portions of some trade venture parceled out to participants. Today, many companies keep a portion of their profits (referred to as retained earnings), and if there is anything left over, it is divvied up and distributed amongst shareholders according to how much equity they have.

Dividends are paid monthly, quarterly, semi-annually or yearly. A special dividend may be issued at any time, if a company feels it is warranted. This is in addition to a regular dividend. While normally paid in cash, it is possible for dividends to be settled as store credits (if the investment is in a retail consumer cooperative) or as shares in the company (these are either bought on the market or created new). When you hold shares in a dividend paying company, you can receive regular cash payments without doing anything other than hold the stock.

Income from Dividend Reinvestment Plans

One of the most popular ways to take advantage of dividend paying companies is to invest using dividend reinvestment plans. Instead of receiving a regular cash payment, your dividend is used to automatically buy more shares in the company. It is like receiving free shares. You do not have to actively buy them, and in many cases you avoid the transaction fees that come with making purchases of additional shares. DRIPs can be a way to help grow your investment portfolio for the future. It is a plan that delays the gratification of receiving cash until a later date. You don’t get the cash as part of a regular income stream, but you do end up with a larger portfolio. If the company’s stock does well, a DRIP can lead to higher returns overall.

Many companies offer DRIPs to stock holders. In fact that there are more than 1,000 dividend-paying companies, and a large portion of them offer DRIPs. Most banks and other financial institutions pay dividends, and many offers DRIPs. Some other companies that offer DRIPs include:

1. General Electric (GE)
2. Kraft Foods (KFT)
3. AFLAC (AFL)
4. Allstate (ALL)
5. Merck (MRK)
6. Marriott International (MAR)
7. Exxon (XOM)
8. IBM (IBM)
9. Intel (INTC)
10. Verizon (VZ)
11. UPS (UPS)
12. Wendy’s (WEN)
13. Hershey (HSY)
14. Waste Management (WMI)

It is important to understand that DRIPs often come with requirements. Some companies require that you own a minimum amount of shares before participating in a DRIP. Others insist that shares in the company be held in your own name, rather than in the name of a brokerage. There may also be restrictions on when you can sell your shares if that need arises. Before you invest, you should understand the requirements expected by the companies. You should also be comfortable with owning fractional shares.

DRIPs encourage good investing habits

Another often overlooked advantage of owning a stock through DRIPs is that it forces your portfolio to do ‘dollar cost averaging‘. This is a method of investing where same amount of cash is invested each period to buy additional shares. When the stock price is high, less number of shares will be bought and when the stock price is low, more number of shares will be bought. This has an effect of keeping the cost basis of the shares low.

Even if you chose to do your investments through a broker (keeping your shares in street name as opposed to taking a stock certificate), you may still be able to set up a dividend reinvestment program. Many brokers today offer an option to reinvest your dividends in additional shares as the dividends are received. Most such offerings are complementary, meaning you will not be charged additional transaction fees or commissions. If you would like to know more about this, please check with your stock broker.

Dividends in funds

It is possible to include dividend paying stocks in funds. Mutual funds and ETFs often include dividend paying stocks. The advantage of owning funds that focus on dividend-paying stocks is that your dividends could be more frequent and uniform than if you had owned a few stocks directly. This is because the funds can be more diversified than an individual portfolio can be, and while it may own a few stocks that pay semi-annual dividends, it probably also owns many other stocks that pay quarterly or even monthly dividends. You should realize that, even if your fund is tax advantaged, you may have tax obligations on the dividends you earn.

Dividend paying stocks can be of great benefit to you, whether you choose to use them as a source of passive income immediately or whether you decide to use DRIPs to grow your portfolio for the future. However, it should be remembered that dividends can be cut. In these economic times, many companies have slashed their dividends in order to reduce costs. You should understand that, just like any other investment, there is the risk that the returns will not always be as high as you would like.

Photo: David Niblack