When you're first starting out in the investing world, it can be discouraging to see a $5 dividend check here or $10 payments there. With the concept of eventually living off of your passive income stream, it seems like such a large jump to get from pennies a day to thousands a month. In turn, it can be easy to give up quickly or at least not put as much effort into the process from the beginning.
To combat this type of thinking, I believe that it can be useful to set up intermediate goals. Instead of thinking about a large round number in the future -- say $1 million or $40,000 in annual passive income -- let's break it down a bit.
Often I like to talk about covering expenses with your investments as a first step to see the investing process working. You start small. For instance, perhaps your monthly cereal expenditure equates to $15 or so. That's $180 for the year. Kellogg (NYSE:K) presently pays a $0.50 quarterly dividend, or $2 on an annual basis. If you accumulated 90 shares, you'd begin to generate $180 annually -- effectively covering your cereal expenditures for life.
That makes sense as a good first step to me. You start at $0, and then you think about a goal that can be accomplished in the short term. In this case it would take 90 shares of Kellogg (at a current cost of about $6,500) to have breakfast covered. Whether this takes you a quarter or a year or two, the idea is to set out an achievable goal to align your aim. You're not thinking about retirement, you're thinking about taking care of breakfast first.
Once you start to hit some intermediate goals, you can begin to up the stakes. Once more thinking about covering an expense makes sense from a goal setting standpoint, but keep in mind that you're not limited to only investing in the businesses you purchase from (although that's a reasonable place to begin looking). With this concept in mind, I wanted to explore the idea of generating $100 a month from a security like Microsoft (NASDAQ:MSFT).
Microsoft has a unique history that differs a bit from your typical dividend growth company. During the 2005 through 2014 period, investors would have seen a 7.4% annualized gain, turning a starting $10,000 investment into $19,000 or thereabouts. When you see that sort of start and end point, it's easy to imagine a nice smooth linear uptrend. Yet that has hardly been the case.
The revenue growth was quite impressive, coming in at over 9% annually. The quality of those sales had decreased slightly, resulting in a lower profit margin and company-wide earnings growth of just over 6% per year. In addition to the dividend, the company has also been retiring a fair amount of shares -- roughly one out of every four shareholders have been bought out in the last 10 years, resulting in EPS growth of about 9.5% per annum.
However, the roller coaster ride wasn't over quite yet. The company's earnings multiple went from about 21 down to 16, resulting in share price growth of less than 6%. Add in the dividend and you come to a total return of just over 7%. And that's prior to thinking about the massive volatility that previously occurred around the tech bubble.
Which brings us to today. During the second fiscal quarter of 2016, Microsoft had $96.5 billion in cash equivalents and short-term investments (that's ignoring all other assets), as compared to total liabilities of $96 billion. And there are other things to like about the business, in addition to the strong balance sheet. Microsoft stands to benefit from increased cloud use and continues to milk the cash cow legacy businesses, as the Azure platform grows rapidly. Moreover, analysts expect intermediate-term growth to come in near 10% per annum.
Naturally future prospects do not have to come to fruition, but this type of thing nonetheless lays out the groundwork for why an investor might be interested in the company and in this case generating income from owning the security.
For a long time Microsoft did not pay a dividend and was better known for its exceptional growth and sky-high valuation. But, as noted above, a lot has changed in the last decade -- especially on the dividend front.
Back in 2003 the company initiated a dividend, and in 2004, Microsoft made its income presence known in big way with a large special dividend. Since 2005 the quarterly dividend has increased by an annual rate of about 15%, with the current mark sitting at $0.36. Based on a share price near $50, this equates to a starting dividend yield of about 2.9%.
Now let's think about getting to an intermediate goal. One hundred dollars per month equals $1,200 per year. So if you wanted to generate this expected amount from Microsoft today, you would need to own about 833 shares. The payments would be quarterly, but the annual amount would be roughly correct. At present this income stream from Microsoft would cost around $42,000.
For some that's possible, but for most that sort of thing is presently out of reach. Yet we need not despair quite yet. You can get there over time. Moreover, there are some things that will help you along the way, namely: organic payout growth, reinvestment and new capital.
Microsoft presently pays out around half of its profits in the form of dividends. Earnings are expected to grow reasonably quickly -- near 10% -- over the intermediate term. Taking these two items in together, and using a bit of caution, perhaps Microsoft could increase its payout by 6% annually. Here's what that might look like:
Year 1 = $1.46
Year 2 = $1.55
Year 3 = $1.64
Year 4 = $1.74
Year 5 = $1.84
Year 6 = $1.95
So instead of needing to accumulate 833 shares, you could think about it as needing to accumulate 615 shares after 6 years (granted the purchasing power would likely be less, but the idea is that organic dividend growth can help in this endeavor).
The second part of getting there over time is the concept that reinvesting will boost your total income growth rate. Imagine that you have saved up $5,500 for the year to invest in Microsoft. Naturally this could instead be invested in a collection of holdings, but we'll use Microsoft in this instance to illustrate the concept.
A beginning $5,500 investment would purchase almost 110 shares. The $1.46 annual expected dividend equates to receiving $160 in annual dividends (already on your way, now collecting an average of $13 per month for this decision). At the end of the year (or before) you could choose to spend those payments or reinvest.
If you spent every dime of dividends, you would still anticipate more income next year. You'd keep your 110 shares and expect next year's $1.55 per share payment to generate ~$170 in annual income -- or approximately a 6% increase using round numbers. Incidentally, this is a great appeal for dividend growth investors: getting a raise each year for doing nothing.
Of course if you elect to reinvest, your income prospects can improve. At the end of year one you have $160 in cash dividends. With this you could elect to add say 3 new shares of the company. In turn, your annual expected cash flow would go up to ~$175 or so instead of $170. You were able to increase your annual dividend income by 9% instead of 6%. This doesn't seem like a large difference to start, but it begins to compound over time.
The third avenue that you have available to you is adding new capital. If at the start of the second year you elected to invest another $5,500, you could effectively double your share count (with reinvested dividends included and assuming a higher share price). Your anticipated income for the year would now be around $345. From there you could reinvest the funds and add new capital again, repeating the wealth and income building process.
After six years of investing $5,500 and reinvesting, your annual expected income would be over $1,200 -- you've reached your intermediate goal. From there you could think about reaching your goal in purchasing power terms, or else keep on going toward the next mark.
You'll find that once the process starts to build -- from a $5 check, up to $15 a month, to $50 and then $100+ month ($500+, $2,000+ etc) -- the enjoyment begins to build. Suddenly you have passive income coming in that can generate its own passive income making machines.
In short, it's not about Microsoft or any security in particular. And it's not even about a given level of passive income. Instead, the concept is to figure out your goals and "back out" a way to get there. In this particular example, if you saved $15 a day for six years, you could have an asset generating $100 a month or more on your personal balance sheet.
Once the ball is rolling, with more and more passive income to deploy, the motivation tends to become inherent. The process becomes more enjoyable. You can adjust for your personal ambitions; the important part (and sometimes most difficult part) is getting started.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.