How do dividend-bearing stocks work?

As I’ve mentioned several times recently on The Simple Dollar, one of my biggest areas of thinking in terms of personal finance right now is how to create a secure future for myself and my family. Right now, except for our mortgage (which has a pretty low interest rate), we’re debt free. We own both of our cars and they won’t need replacing soon. Our bills are relatively low. We have a very healthy cash emergency fund. After all that, we still spend substantially less than we earn.

Our question then becomes what can we do with that difference to secure our financial life in the future?

We have several avenues, of course. For one, we could simply accumulate cash in savings accounts and CDs. For another, we could buy highly secure investments that would return a bit more than savings accounts. We could also seek to simply maximize returns by investing in stocks that would give us a large return over the long haul.

However, after a lot of discussion, our biggest interest is in turning that money into a passive income stream while also using that money to support companies we believe in. We’d take our money and put it into a handful of companies we believe in – or at least ones that aren’t involved in businesses we find unethical or problematic – and then use the dividends paid by those stocks as an income stream. Our goal would be to avoid selling those stocks for a very long time, if ever, as the purpose would be to have a steady stream of income via the dividends.

Personal finance 101 here: dividends are small payments given to the holder of each and every share of a company on a regular basis. Many companies do this as a method of encouraging investment in that company and returning value to the people who own the company (the shareholders).

So, how would this work?

Let’s take a look at, say, Coca-Cola (stock symbol: KO). Coca-Cola’s stock pays approximately a 3% yield each year, which means that if the stock is valued at 100 steadily over the course of a year, you would receive $3 over the course of that year in dividend payments. So, if I bought one share of Coca-Cola today (at 67.40) and it held that value, I could reasonably expect to receive $2 over the coming year.

Let’s say, right now, we bought $20,000 in Coca-Cola stock. That would net us about 297 shares of KO, which we would then sit on for the time being. Each quarter, we’d earn a dividend payment of around $0.45 per share or so, based on the historical data, and that amount will likely inch upward over time. That’s a payment, each quarter, of $133.65.

$133.65 every three months? That’s not much, it seems. However, there are a few important things to remember. First, those payments will go out as long as the Coca-Cola Corporation exists and continues to pay dividends. Second, if I want my initial investment back, I can get some significant component of it back by simply selling the stock. If the stock is up, I could make some money just from selling the stock. If it’s down, I still made money from the dividend payments.

There’s also the question about future savings. If I were to continue to invest future savings in other dividend-paying stocks, I could eventually reach a point where the dividend payments are producing a significant portion of my personal income. This is exactly how many older and retired businessmen live – they earn income from the dividends on their stocks, and if you have enough, you can easily live off of them.

Let’s say, for example, we bought $2 million worth of Coca-Cola stock – 100 times as much. That would give us a dividend payment every three months of $13,365.00. That would be a very nice income stream, indeed, especially considering we would just sit back and collect the checks.

Now, what about the future? There are two factors to look at here.

First of all, will the actual stock value of Coca-Cola go up or down? Over the last ten years, the stock has held fairly steady. Even during the stock bubble bursts of 2000 and 2008, the value of KO didn’t drop as much as the overall market, and it’s up about 30% over the last decade. If you go back even further, it’s held steady value for a very long time. Why? People like to drink Coke. It’s reasonable to think that it will continue to hold value. Even more important, the company has been in good financial health for a very long time, with little debt and lots of revenue. It’s stable and steady for the long haul.

Second of all, will the dividend for Coca-Cola go up or down? This is much harder to tell, but one of the big shareholders of Coca-Cola, Warren Buffett, predicts that the yield for KO will go up about 7% per year over the next decade. In other words, Buffett believes that the yield will gradually slide upward from about 3% (where it is now) to about 4%. There’s also the fact that Coca-Cola’s dividend history is very long and very steady.

A final question for Sarah and myself would be whether we would want to invest in Coca-Cola. Are they in a business that ethically bothers us? Do they have business practices we support? That’s still an open question, but it’s a key part of the thought process we would have about any company we would invest in. We want to find dividend-bearing companies that aren’t engaged in businesses that ethically bother us and, preferably, do at least some things that we ethically support.

Is this an avenue we’re going to take? It’s certainly an avenue that’s a part of our discussions right now, along with eliminating our mortgage and focusing on maximizing our savings to buy a home in a different location. All of these have various appeals and, as with most things in our life since we’ve turned our financial situation around, we’re looking at each one before making a big leap.

Since we simply don’t live a lifestyle that involves spending all the money we take in – nor do we have an interest in that – we’re left with the great problem of deciding what to do with the remnants. This is the reward of living frugally and within your means. This is the reward for not buying stuff just because you happen to lightly desire it today.

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