Our end goal is to someday offset expenses with passive income.
However, inflation can easily eat away at invested income.
Therefore, dividend growth is necessary to add income without additional capital.
Tracking ones dividend income and the increase in passive is a common endeavor among the investing world; it is an easy way to see progress towards ones goals and provide tangible rewards that don’t require selling your stock. We meticulously track our income payments month over month, calculate the ratio of our income to expenses, and await the day when dividend income provides enough cash flow to match those expenses. Small investments are made each month, each with the goal of providing more income over the next twelve months and beyond. However, no matter the progress that is made in increasing passive income from dividends and other sources, and unless one’s savings rate is well over 50%, it will be difficult to offset expenses with only the raw dividends from an invest.
Expenses and the Capital to Cover Them
For starting principles as to why dividend growth is essential, it is first not enough to merely view the cost of something as merely the sticker price you paid to acquire the good or service. To begin, you must a look at each purchase you make in terms of the amount of capital it would take to generate enough income to cover that purchase. For example, that $10 lunch at work today would have taken $250 worth of an asset that yields 4%. Since most assets only pay you in quarterly installments, that lunch actually took $1,000 in capital at a 4% yield to cover the cost. Framing your expenses in this manner allows you to see the amount of capital you will need to accumulate in order to ultimately offset your expenses.
Second, and most central to the importance of dividend growth, is the specter of ever increasing costs as one progresses through life. It is common to see financial writers bemoaning the evils of lifestyle creep, or when one matches increasing incomes with ever greater expenses. People see their annual incomes increase with each passing year as their careers progress, and they purchase material comfort consummate with the greater cash flow. However, and more specifically to the industrious types that frequent this website, one can watch their expenses slowly creep up over time without making large purchases that saddle them with new fixed costs. Inflation, which eats away at investment returns, will also slowly but surely offset your savings efforts. In fact, it is not unreasonable to assume that one’s expenses can easily expand by an average of $10 monthly, and thus be saddled with $120 in extra expenses each month in one year’s time. First off, if you rent, a small 2-3% increase in rent can account for $30-$50 in extra expenses each month from the previous year. Next, an increase in your cable bill can easily add $10 in monthly expenses. Food prices can go up 3%, and the $200 you spend weekly for a family of five is suddenly $206 a week. Before one realizes it, one year from now your monthly expenses have gone up by $100 or more without any noticeable increase in your standard of living. Suddenly, you now have to invest $30,000 extra just to break even with cash flow on those expense increases.
The Power of DRIP and Dividend Increases
Therefore, one must find a way to keep growing their passive income without finding additional capital to invest. Fresh capital from your investments can help here. If you automatically DRIP these dividends, you quickly add to your capital base without having to invest more. This in turn will also increase your passive income, and help to send more in dividends your way next quarter without additional effort. In this way, cash flow helps to beget more cash flow. Also, you can choose to synthetically DRIP your dividends by collecting them as cash and redeploying them at months end.
However, running a DRIP is necessary but not sufficient to increase your passive income. You must also invest in stocks that can send an ever growing stream of income your way. An illustration from the Berkshire Hathaway letters can help to illustrate this point. First, you must think of the companies you invest in and your career as being your “company” that has retained earnings. Each year this company reinvests these earnings (your salary and dividend income) into other stocks to increase its earnings. However, this generates the manager of the business, you, no applause. Instead, Buffett illustrates these earnings as a savings account; each year the savings account generates interest income, and that interest is reinvested in the savings account. That reinvested interest will make sure that next year’s earnings will be greater, regardless of any managerial talent. Similarly, Buffett does not give managers kudos for reinvesting earnings and growing net income. Instead, the manager must also find ways to grow net income independent of reinvested earnings and without additional capital. This is the same thing we must do as managers of our own business; we must grow our income both with and without investing new capital. Our way of doing this is by selecting stocks that have a good record of dividend growth, and can continue to grow earnings in the future. In this way, we are growing earnings without reinvesting any capital.
When viewed in this manner, the importance of dividend growth can easily be shown. First, imagine that you own 100 shares of Johnson and Johnson (NYSE:JNJ). This stake took $7,500 in capital to accumulate back in early 2013, and it paid you $.61 a share for a total quarterly payment of $61. Today, that stake is worth nearly $12,000, and without reinvesting any dividends or purchasing any new shares, you now are bringing in $80 quarterly dividend payments. This is the equivalent to investing $2,500 worth of fresh capital in JNJ, but the selection of a stock that increases their dividend payments allowed you to still increase your income while letting you invest that $2,500 in opportunities elsewhere to generate further income.
Offsetting Expenses with and without Dividend Growth
With all the pieces in place, we must now look at how our expenses with no dividend growth or DRIP, but we are investing new cash. The other scenario will be our expense coverage with dividend growth, DRIP and new cash investment. We assume that you start with a base of $50,000 in assets, and are able to contribute $30,000 annually in additional capital from your savings. This $30,000 will grow at 4% per year to match increases in your salary. Your assets will also generate 4% in passive income. Further, we assume that your annual expenses are $60,000 annually, and those also increase at 4% annually.
In running this scenario, we quickly see that it will take a very long time to generate enough passive cash flow to offset your expenses. This is seen in the expenses less dividends column; in the first year you generate $2,000 in passive income and have $60,000 in expenses, which means you still have $58,000 more in expenses to offset. This spread will get bigger for several years, and will not start to decrease until year 45. Further, it will be 77 years under this scenario before passive income offsets expenses completely and generates a surplus. Considering I will be well over 100 in this scenario, this is a somewhat depressing outcome. It is also sobering for those of us who may want to accumulate dividend paying stocks quickly and may not give much thought to growth. Below is the depressing picture of how this scenario will unfold:
|Year||Beginning Amount||New Contributions||Expenses Less Dividends|
Obviously, the above is not an optimal scenario. In order to more quickly offset expenses with passive income, we will need to increase our earnings base by reinvesting our capital and seeing cash flows grow automatically due to our “managerial talent”. The same assumptions are made in this scenario, however, we also assume that all dividends are reinvested and all dividends are increasing at 5% annually (This is a modest assumption). With this, the situation immediately becomes rosier. The expenses increased faster than income for the first eight years, but the ratio decreased quickly starting in year nine. In year 37, passive income finally offsets your expenses and leaves a little something left over. With this simple illustration, the power of modestly increasing dividends is easily shown.
|Year||Beginning Amount||New Contributions||Expenses Less Dividends|
Life is an ever increasing battle against inflation and controlling expenses. Setting aside money for the future and investing it a reasonable rate is good, but not sufficient to offset the effects of inflation if we want to someday live off our passive income. Instead, we also must realize the help that is given by dividend growth and select assets that will deliver ever increasing streams of income.
Disclosure: I am/we are long JNJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
written by Drew Allen