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How to Use Dividend Growth Investing to Earn Passive Income

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

Some businesses use part of their profits to pay dividends to shareholders monthly or quarterly.

Some businesses use part of their profits to pay dividends to shareholders monthly or quarterly.

The Search for Financial Independence

If you're interested in creating a passive income stream, you've probably considered a number of different approaches to help you move closer to achieving financial independence. Owning and renting out real estate is a great potential generator of consistent cash every month, but it also comes with some headaches. There's a pretty high price barrier to enter (unless you take on a lot of debt), and you have to either be a landlord yourself or pay a property manager.

Owning intellectual property you can monetize—like web articles or YouTube videos—is another path that works amazingly well for some folks, but it can take a long time to develop the skillset you need to make some serious cash.

Owning your own small business and getting "mailbox money" from the profits (and swimming around in a giant money bin like Scrooge McDuck) may sound amazing, but most small business owners never reach such a level of automated success.

Most people who are interested in generating consistent, reliable passive income, then, end up taking a good look at the stock market, and many conclude that one particular style of value investing works best for them: dividend growth investing.

Dividends and the "Honey Pot" Concept

Most methods of investing involve buying a stock at one price and selling it at another (ideally higher) price. This ultimately means that the most important thing you're looking for is for the price of a stock you own to increase over time. In other words, you're trying to buy low and sell high.

This is incredibly intuitive for most people, and when non-investors think of the stock market, this is almost always what comes to mind. The downside, of course, is that if you view a stock as the ownership of a tiny piece of a business, you tend to do a lot of research in order to find a great business that fits in well with your portfolio and personal style. You tend to really like the businesses you own. Selling them means you lose that relationship, and then you have to find another place to invest your money. Is it back to square one?

Now, imagine a scenario where you get to keep the underlying stock, but you also get to make money. John D Rockefeller, one of the richest people who ever lived, famously quipped that the only thing that made him happy was to see his dividend check rolling in each month.

Kevin O'Leary (of Shark Tank) used a helpful analogy—the honey pot. You can scrape the honey that runs off from the sides, but you don't want to touch the original honey inside the pot. The honey in the pot represents the principle of your investment, and the honey dripping down the sides represents the dividends you are paid. The idea here is to leave the honey in the pot alone, and use the honey that drips down the sides (the dividends) for living expenses (or, even better, to reinvest in the underlying security).

What Are Dividends and How Do They Work?

Dividends, the honey from the side of the pot, will pay you simply for owning the stock. When a company has excess free cash, the life-blood of any business, it can basically do one of two things with it: reinvest in the business or pay the owners.

Reinvesting in the business might mean paying down debt. It could also mean spending on a one-time expense to help grow the business—like a purchase of a new factory (manufacturing) or a software license (tech). It could also mean acquiring another company (or another income-producing asset).

Paying the owners is usually done in one of two ways: buybacks and dividends. For every share the company buys back, you own a slightly higher percentage of the company, meaning your shares are worth more. Dividends, of course, are periodic cash payments to security owners—the honey on the side of the pot. Most companies pay dividends with quarterly payments, although some pay monthly.

If a company reinvests all of its free cash, it does not pay dividends. At the other extreme, if a company pays out 100% of its free cash in the form of dividends to owners, it's not reinvesting anything back into the business. That's why—at least with most "mature" businesses (and by "mature", I just mean the business has been around long enough so that it doesn't have opportunities in order to grow the business with 100% of the free cash)—it's usually best to go with a reasonable blend of reinvestment and paying back owners.

f the business is growing, then there's a really good chance that the underlying stock is going to be worth more over time so that if shareholders do decide to sell, they would hope to do so for more than their initial investment. Even better, if a company's earnings grow, it should be able to increase its regular dividend payment over time. This is precisely what the dividend growth investor wants.

Broadening Your Investing Horizon

When you start looking at investing in stocks with something other than the buy low-sell high mentality, you immediately conclude that a much longer time horizon needs to be considered. The idea is for you to buy the company and then sit back and be paid. On the other hand, if a stock gets too expensive, you can always sell it for a profit, especially if you have an idea of where to find another good bargain.

The nice thing about being a dividend growth investor is that you don't mind holding the stock for several years at all, especially if the underlying company is becoming more valuable over time. The dividend that grows over time needs to stay ahead of inflation so that the percent of money you're earning from your stock continues to go up in real terms, not nominal terms.

If you can stay well ahead of inflation and even widen the gap through a growing company, you've found an awesome sweet spot where your income grows over time without you having to do anything at all. Even better, the underlying asset will continue to rise in price, meaning that your wealth will continue to grow.

If you reinvest the dividends into the stock instead of paying yourself, you can help the stock grow at an even faster rate. Now we have a honey pot that grows, and that's something we can all get behind.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2021 Andrew Smith