Choosing A Stock Part 4: Income Investing

This article orginally appeared on DriveWealth.

Welcome to Part 4 of the “Choosing A Stock” mini-series. If you missed Part 1, Part 2, or Part 3, I encourage you to go back, check them out, and give them a read; they can be found on The Drive. In Part 4, we will be focusing on a stock picking strategy that is perhaps one of the most straightforward yet, but also often one of the most rewarding and reliable. This week’s topic is income investing.

The fundamental tactic of income investing is to purchase equity (stock) in companies that will provide a steady stream of income. What is steady income? Well, it can come in multiple forms. For instance, many investors will think of fixed-income securities (such as bonds) when considering steady income streams. But, steady income streams can also be found in stocks that pay good dividends. So, what stocks can provide solid dividends? Good question.

A lot of the time, investors practicing an income investing strategy will look towards very established (often older) companies, which they deem to have reached a big enough size that they will no longer continue to have rapid growth (at least in the short term). Since these types of companies tend to be in industries that are not quickly expanding, they are more likely to pay out retained earnings as dividends to their shareholders, rather than reinvesting them immediately. As a result, investors (shareholders) are more likely to be pleased with their steady investment payouts, as opposed to more volatile investments.

Naturally, there are some industries where dividends are much more prominent than others. For example, utility companies are well known for their somewhat more reliable dividends because the major players are very established. However, successful income investors do not only look for the companies that pay the highest dividends in terms of dollar amount. The much more significant figure to focus on is the dividend yield.

Simply put, the dividend yield is calculated by dividing the annual dividend per share by the share price, but what does that tell you? Well, it tells you the actual return that a dividend gives the owner of the stock. For example, a company with a share price of $500 and a dividend of $25 (per share) has a 5% dividend yield. This means that the owner of the shares will receive a 5% return from the dividends. For a point of reference, according to Dividend.com, the average dividend yield for companies in the S&P 500 is 2-3%, so 5% would be fantastic. For most income investors, this is good news because they are generally seeking much higher returns than 2-3%. Moreover, many aim for at least a 5-6% yield, which would produce a pre-tax income of $50,000-$60,000 annually on investment of $1 million.

By now, the basis of this strategy should be simple to understand: invest in good companies with sustainable high dividend yields to receive a steady stream of income over a long period of time. It is also reasonably reliable, which is why investors are more inclined to use this strategy with large sums of money – or sums which represent a higher percentage of their total bank rolls – than they would if they were making much riskier investments.

Ultimately, the thinking behind income investing is much more straightforward than many other strategies, and therefore, much less intimidating for less experienced investors to try. Like all forms of investing, though, income investing does come with risk and is not completely fool proof. After all, playing the stock market, by nature, comes some level of risk that an investor must be willing to incur. That said, income investing can also be a great and fairly reliable strategy for individuals who do the due diligence necessary to make an informed investing decision. Thank you for reading Part 4 of the “Choosing A Stock” mini-series, and please stay tuned for Part 5!