With growth stocks being slammed into the ground these past few months, dividend stocks have started getting a lot of attention from investors. And for individuals looking to generate a sizable and consistent passive income, there are a select number of stocks with monthly dividends.

As exciting as the prospect of seeing money arrive in my account each month passively is, there are some important factors to consider. Namely, how dividends actually work and the risks involved. So let’s dive into the weeds and uncover what I believe are the best stocks with monthly dividend payments.

What are dividends, and why do companies pay them?

Typically when a firm has no better use for the capital on its balance sheet, it chooses to return the excess to shareholders. There are different ways of doing this, but a dividend payment is amongst the most popular.

Why do businesses do this?

There are a few reasons:

• Dividends are an excellent way of attracting new investors and maintaining current investors.
• Returns profits to shareholders who are the owners.
• Maintaining a high and consistent payout ratio can signal business strength, making it easier to secure external financing through equity.

What are the risks of investing in stocks with a monthly dividend?

A monthly dividend stock is a popular investment for retired personnel because they provide a steady stream of income. Or at least, that’s the plan.

A carefully selected list of stocks with monthly dividends can lead to a healthy, growing income stream and desirable portfolio growth in the long run.

Furthermore, when combined with any other state or private pensions, it can create quite a comfortable retirement.

Having said that, there are several risks to consider:

• Value Traps – Not every stock with a monthly dividend is worthy of investment. It’s easy to become allured by a cheap P/E ratio. However, sometimes shares are trading at low multiples for good reasons. And even if the company can maintain its dividends, an investor’s return can still drop into the red if the share price plummets.
• Yield Traps – Much like a low P/E ratio, a high yield can also lead investors astray. Don’t forget that dividend yield is a function of the stock price. If the stock drops, the yield goes up. And in some cases, this can push the payout into double-digit territory. However, typically this only happens when something major has gone wrong that will most likely result in a dividend cut or even outright cancellation.

Beyond these primary traps, the general state of the stock market is also something to consider. As we’ve seen over the last couple of years, once thriving businesses can quickly be diminished by external factors such as economic downturns, supply chain disruption, and volatile foreign exchange rates.

What are stock dividends, and how do they work?

In most cases, dividend distribution is executed using cash. But companies can also choose to offer shares instead.

The process is a bit more complicated and can cause equity dilution if new shares are being issued. But for a business seeking to reward shareholder loyalty, this is one way of distributing profits without impacting the cash balance.

Of course, value is only created for dividend investors if the business can thrive in the long term.

An often forgotten advantage of receiving a stock dividend as opposed to cash is the more favourable tax treatment for investors.

Unless shares are being held in a tax-efficient account like a Stocks and Shares ISA (United Kingdom) or a Roth IRA (United States), cash dividends are taxable at the point of receiving them. However, a stock dividend is only taxed at the point of sale in the future.

As wonderful as that sounds, in my experience, a firm that starts paying out a stock dividend when it has historically paid a cash dividend is usually a sign of financial weakness and requires careful scrutiny.

Should I invest in monthly income shares?

In my opinion, the decision to invest in monthly dividend stocks isn’t any different from choosing any other asset class.

They have quite a few benefits, such as:

• A (hopefully) steady stream of dividend income.
• Stocks with monthly dividends typically have high trading volumes making them easy and cheaper to buy and sell.
• The compounding effects are accelerated if dividends are reinvested by an income investor.

But they also carry a level of risk that needs to be considered. That’s why it’s critical to always research and investigate the business thoroughly to avoid making a poor investment decision based on the promise of passive income that may never materialise.

How to choose stocks that pay a monthly dividend

Finding the best investment opportunities among stocks which pay monthly dividends can be a daunting task. But, in my experience, the best way of identifying the best investments in this space is by checking for the following characteristics:

• Long-term profitability – Companies that expect consistent growth in future profits are more likely to produce a reliable income.
• A decent earning growth – As an investor, I believe earnings growth and dividend growth should be consistent and grow parallel to each other. After all, if dividends are growing faster than earnings, this is not sustainable in the long term.
• Healthy cash flow – Cash is king. And if a business is generating less cash flow than what it needs to afford its dividend payout, then a cut may be on the horizon.
• Low debt levels – Businesses with high debt must prioritise their profits toward debt repayment. With interest rates rising, more cash flow will be consumed by the interest expense of a group’s loans, making less money available to shareholders and, in turn, dividends.

What are the best monthly dividend stocks?

With all that said, what are the best shares on the stock market offering a monthly dividend payment?

This is a highly subjective question with no clear answer. But personally, I like the look of these businesses for my income portfolio:

Saima Naveed does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and, therefore, may differ from the opinions of analysts in The Money Cog Premium services.