Buying income shares in 2024 might be one of the smartest moves investors can make. The boosted dividend yields created by the recent stock market correction offer investors a rare opportunity to snap up some chunky passive income.
So if I had £5,000 to spare today, here’s how I’d expect to start earning a £300 annual dividend.
Quality over quantity
Looking across the FTSE 350, there are more than 60 companies offering a yield of 6%. Diversifying my capital across these businesses to lock in such a yield would provide a passive income stream of £300 a year. And considering some shares are even offering yields as high as 10%, I could potentially boost this to £500!
Unfortunately, investing is rarely this simple. Stocks that offer a sizable payout can be a terrific source of income. But that’s often an exception rather than the rule. That’s because dividend yields are primarily influenced by movements in share price rather than management bolstering shareholder rewards. As such, whenever a company’s market capitalisation tumbles, the yield goes up.
Sometimes rapid downturns in valuation are unjustified, especially during a stock market correction when nerves and emotions are running high. But usually, such drastic reactions are triggered by challenging or even thesis-breaking problems.
As such, an investor may end up investing in a 6% yielding stock only to see management cut dividends to preserve capital a few weeks later. Therefore, when it comes to building a passive income in the stock market, the quality of a yield is far more important than its size.
Earnings versus free cash flow
A popular metric to judge the health of a firm’s dividend is the payout ratio. By comparing the amount of dividends paid as a proportion of net income, investors can quickly see how much earnings are being redistributed. A larger value suggests less sustainability, especially if the company’s ops were to be disrupted.
However, relying on net income can be wildly misleading. That’s because companies often report one-time gains or paper profits that can make a dividend look more affordable than it actually is. An example of the latter would be changes in the valuations of properties for a real estate investment trust (REIT).
When property prices were rising, REITs were reporting staggering earnings despite most of it not actually resulting in cash in the bank. Today, the opposite is happening. REITs are recognising massive losses due to the fall in property prices despite rental income rising.
To avoid this misleading trait, I prefer to use free cash flow instead of net income when calculating the payout ratio. That way, I’m comparing dividends paid to the actual excess cash generated by a business.
