When I consider making an investment in a blue-chip stock, I make projections about what kind of earnings growth and dividend growth to expect over the coming 5-10 year time frame. Of course, there is no guarantee that I'll be right, but failing to plan is planning to fail and all that, as the saying goes. If you aim to generate $10,000 (or whatever amount you desire) in passive income each year, you have to take active steps to put yourself in the position to get there. As nice as it would be, the tooth fairy doesn't deposit $250,000 into our bank accounts so that we can create a $10,000 stream of income assuming a 4% starting yield.
Today, I'll share with you my thought process on how I would go about trying to set myself up to generate $1,000 in annual tax-free dividends from BP (BP) (obviously, you can substitute the company of your choice. The reason I chose BP is because it is one of the few large-cap companies that appear "buyable" at today's levels and because the company seems poised to grow earnings and dividends by 8-12% annually over the long-term).
Anytime we start a conversation about future income expectations, we have to make assumptions about the dividend growth rate and then combine it with our starting income level and time horizon.
If you check out a company like BP, you can see the directive from the management team that the long-term growth of the dividend in line with earnings growth is part of the company's strategy:
Substantial progress has been made in meeting these priorities. This progress gave the board conﬁdence to raise the quarterly dividend by 14% in February 2012 and by 12.5% in October. The increased dividend represents an important milestone on the road to improved shareholder value. We are maintaining a progressive dividend policy, increasing returns to you, in line with ﬁnancial performance and outlook.
Right now, the analysts predict 10.5% earnings growth and 10.5% dividend growth from BP through 2018. That seems optimistic, so in the interest of conservatism, we'll project 8.0% earnings growth and 8.0% dividend growth and extend it out over the decade (you can personally adjust the assumptions as you see fit).
If I targeted $1,000 in tax-free dividend income from BP by 2023, here's how I would go about achieving it:
First, I would calculate the expected dividend payout in 2023. Right now, BP pays out $0.54 quarterly, or $2.16 annually. If that grows by 8% annually for ten years, we'd be looking at an annual payout of $4.79 per share.
In order to figure out the asset base necessary to get that $1,000 in annual income, you take the $1,000 and divide it by the $4.79 per share payout amount. That means that you'd need a starting base of 208 shares to get there.
Additionally, we want to generate that money tax-free, preferably in something like a Roth IRA. Right now, BP trades at around $42 per share. For an investor to get his hands on 208 shares, he would have to pay $8,736. Right now, a Roth IRA allows you to deposit $5,500 per year into an account. To put it in monthly terms, you could deposit $450 into a Roth IRA each month. To get your hands on 208 shares of BP, you'd have to set aside $450 each month for about twenty months, or a little over a year and half.
That's how you march towards your goals. Determine what your general goal is, and then break it down into individual pieces to see what it would take for you to get there. Maybe you want to get $2,000 in Coca-Cola (KO) dividends fifteen years from now, or $5,000 in Conoco Phillips (COP) twelve years from now. The goals and the stocks that you use to accomplish them are up to you.
But if you want to put yourself in a position to reach those goals, reverse engineer the process and determine what kind of assumptions it would take to get there. If I want $1,000 in tax-free BP dividends a decade from now, I know it would take me about a year and a half's worth of full Roth IRA contributions that are bought at an average price of $42 while the dividend grows at 8.0%. If I pay more than $42 per share or the dividend grows at less than 8.0%, I'll get there slower. If I pay less than $42 per share or the dividend grows at more than 8.0%, I'll get there faster. Oh, and none of these calculations assume reinvested dividends, which operate as a cushion of sorts that allow you to reach that $1,000 dividend threshold even if the actual performance trails your expectations a bit.
This is a technique straight out of the Charlie Munger playbook. He takes complex problems and reverse engineers solutions by breaking them out into concrete steps that allow you to get there. You can accomplish your goals much easier if you can establish the terms necessary to meet them ahead of time. Isolate the variables, make realistic projections about them, and then you can go through life planting the seeds that lead to thousand-dollar dividend trees.