For many, passive income is that elusive dream that seems to exist only in fairy tales. Yet it needn’t be that way! A popular and reliable way to achieve it is through dividend stocks. By investing in companies that regularly distribute profits to shareholders, a hassle-free and steady income stream is within grasp. 

This guide details why dividend investing can be a great way to start earning an income on the stock market.

Why dividend stocks are great for passive income

Many UK companies pay a portion of their profits to shareholders, known as dividends. Here’s why they are an excellent choice for passive income:

• Unlike capital gains, dividends provide income without the need to sell anything.
• Reinvesting dividends helps the investment grow, thereby increasing future payouts (the snowball effect).
• Dividend-paying stocks tend to be more stable, making them attractive for long-term investors.
• Many companies increase dividends over time, helping to retain purchasing power.

How to choose the best dividend stocks

Dividends are never guaranteed so it’s important to choose reliable stocks. Here are key factors to consider when picking the best ones.

• Dividend yield: the yield is the percentage of the stock price that’s paid out annually. While high yields are tempting, an extremely high yield can signal financial trouble. A yield between 4% and 7% is often a sweet spot.

• Dividend growth history: ideally, look for companies with a long history of increasing dividends. I always look for a minimum of 10 years of consistent growth.

• Payout ratio: the payout ratio measures how well a company can afford to cover its dividend payments. A ratio of 100% means it’s spending all its spare cash on dividends — which isn’t sustainable for long. Ideally, I aim for stocks with a payout ratio below 70%.

• Financial strength: strong companies with steady revenue, manageable debt, and good profit margins are more likely to sustain and grow dividends. Always review the balance sheet and check the latest annual report to get an idea of a company’s stability.

Example of a high-yield dividend stock

Let’s apply the above points to a popular FTSE 100 dividend stock.

LondonMetric Property (LSE: LMP) is a UK real estate investment trust (REIT), which means it must distribute at least 90% of its profits to shareholders. This structure makes it a dependable dividend payer, ideal for passive income seekers.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice.

It’s also good for beginners as its business model is straightforward: it generates income from renting properties and passes most of the profits to shareholders. 

However, REITs rely on interest rates, which can impact borrowing costs and property valuations. Economic downturns can also limit demand for logistics properties, curbing rental income and hurting profits. Such risks should always be factored in.

Its dividend yield typically fluctuates between 4% and 6% — a good range for an income-focused portfolio. To match inflation, it’s been increasing its dividend at a rate of 5.27% over the past 10 years.

Make the dream come true

Building passive income with dividend stocks is a popular method that’s helped many investors build long-term wealth. By selecting quality dividend stocks, reinvesting payouts, and maintaining a long-term mindset, a reliable income stream is achievable. 

Whether aiming for extra income in retirement or a way to supplement earnings, dividend investing is a strategy worth considering.