If your purpose for investing in stocks is to create income, you need to choose stocks that pay dividends. Dividends are typically paid quarterly to stockholders on record.
Distinguishing between dividends and interest
Don’t confuse dividends with interest. Most people are familiar with interest, because that’s how you grow your money over the years in the bank. The important difference is that interest is paid to creditors, and dividends are paid to owners (meaning shareholders and if you own stock, you’re a hareholder, because stocks represent shares in a publicly traded company). When you buy stock, you buy a piece of that company. When you put money in a bank (or when you buy bonds), you basically loan your money. You become a creditor, and the bank or bond issuer is the debtor, and as such, it must eventually pay your money back to you with interest.
Recognizing the importance of an income stock’s yield. Investing for income means that you have to consider your investment’s yield. If you want income from a stock investment, you must compare the yield from that particular stock with alternatives. Looking at the yield is a way to compare the income you expect to receive from one investment with the expected income from others.
To understand how to calculate yield, you need the following formula -
Yield = Payout ÷ Investment Amount
Yield enables you to compare how much income you would get for a prospective investment compared with the income you would get from other investments. For the sake of simplicity, this exercise is based on an annual percentage yield basis (compounding would increase the yield). Jones Co. and Smith Co. are both typical dividend-paying stocks, and presume that both companies are similar in most respects except for their differing dividends. How can you tell whether a $50 stock with a $2.50 annual dividend is better (or worse) than a $100 stock with a $4.00 dividend? The yield tells you. Even though Jones Co. pays a higher dividend ($4.00), Smith Co. has a higher yield (5 percent).
Therefore, if you had to choose between those two stocks as an income investor, you would choose Smith Co. Of course, if you truly want to maximize your income and don’t really need your investment to appreciate a lot, you should probably choose Brown Co.’s bond because it offers a yield of 6 percent. Dividend-paying stocks do have the ability to increase in value. They may not have the same growth potential as growth stocks, but, at the very least, they have a greater potential for capital gain than bank CDs or bonds. You may get more than you invest.
