When building passive income, a common preference for investors is the safety, sustainability, or predictability of that income. Personally, I prefer to use dividend stocks to build a passive income. To select solid dividend stocks, investors should investigate the dividend sustainability and the earnings quality. Ideally, I’m looking for dividend stocks that will increase my passive income over time (without me necessarily putting more money in).
According to Talent.com, a good average salary in Canada is $44,801 per year. The general rule of thumb is to save 10-20% of your income each month. Let’s say I make this annual salary and am able to save 15%, which would result in me saving and investing $6,720 each year (or $560 per month).
Dividend sustainability
The big Canadian bank stocks are excellent for passive income, despite their stock prices can be volatile, moving with the ups and downs of the economic cycle. Indeed, the Big Six Canadian bank stocks have paid dividends for over a century and tend to increase them over time. They are some of the most profitable businesses in Canada. So, it makes good sense to own their common shares and be a part-owner of their businesses.
By investing in Bank of Montreal (TSX:BMO) stock today, investors can enjoy an initial dividend yield of 4.8%. Because of higher loan-loss provisions expected in a potential recessionary scenario, the bank’s payout ratio is estimated to be higher than normal — at about 78% of earnings this year. The adjusted earnings show a more normalized earnings power of the solid bank, and it indicates a payout ratio of 46%. I have confidence the bank will at least maintain its dividend. For your reference, BMO stock’s 10-year dividend growth was 6.8% per year.
Notably, the regulator will likely restrict the big banks from increasing their dividends and buying back their common shares to maintain the stability of our financial system during gloomy economic times such as in a recession.
Earnings quality
Quality earnings imply rising earnings per share (EPS) over time that doesn’t entirely rely on share buybacks. Quality earnings are also earnings that don’t dissipate in a recession.
Bank of Montreal’s earnings quality is not bad. Its EPS has increased over time in the long run. However, around recessions, its EPS evidently declined, which also resulted in a stock price decline accordingly. In other words, it could be a good opportunity to accumulate shares on meaningful market corrections for more income and greater total returns potential.
Even during recessions, BMO’s earnings were still able to cover its dividend with leftovers. Since its inception, it has accumulated retained earnings of over $44 billion. As long as it remains profitable, as it has in the past, its treasure chest of retained earnings will only increase over time, which could serve as a buffer for its dividend if needed.
Make a growing passive income
If I were investing solely in BMO stock and I’m able to stick with today’s dividend yield of 4.8%, I would make about $322.56 of annual income on an investment of $6,720 over a year. Actually, that income will increase in the following year, as the bank tends to increase its dividend.
In reality, it would be smart of investors to build a diversified portfolio to generate a safer passive-income river made of streams, such as an income stream from BMO. Specifically, look for dividend stocks with sustainable dividends and quality earnings that are able to increase their earnings and dividends over time.
Moreover, the stock prices of your holdings shouldn’t move in tandem with each other because the underlying businesses should be exposed to different risks. This is easier said than done because even businesses of different sectors or industries are at least partly correlated most of the time. For example, rising interest rates generally lead to a correction in stocks.
