Receiving money without working for it sounds like a dream for many people. But it’s a reality for all sorts, from landowners to songwriters. Many people have a list of ideas for income that take less work, such as renting out a spare room or selling online. But I prefer passive income that really requires very little work at all. So I put some money aside each month in a Stocks and Shares ISA. Then I use it to invest in shares. Here’s how I decide what to put on my list of potential passive income investments.
My passive income list focusses on dividends
There are a lot of companies that are in their growth phase. They could have fabulous prospects ahead. However, due to the stage of their development, they do not generate surplus cash that they can distribute as dividends to shareholders.
While I might find those companies attractive in other ways, they wouldn’t make my passive income list. For example, I own S4 Capital because I think its digital ad network model has lots of room to grow. But it has never paid a dividend, and I don’t expect dividends from it any time soon.
For my passive income list, I prefer companies with an attractive dividend payment history, such as Unilever, GlaxoSmithKline, or British American Tobacco. I have more confidence in a company as a future source of passive income if it has decent business prospects and a strong history of paying out dividends to shareholders.
Why I look at yield
In addition to dividend payment history, I also find it helpful to look at dividend yield for my passive income list. “Yield” simply means the percentage return each year. Different shares can have very different yields. For example, to say that British American Tobacco yields around 7% means that for every £100 in BAT shares I hold, I would expect £7 in income next year.
Remember, that’s just in one year. If I buy the shares now, I pay once, but I expect the dividends to continue year after year. BAT has increased its dividends annually for two decades. That doesn’t mean it will do so in future – companies can cut dividends as well as increase them – but I hope it will.
The reason yield matters so much is because it gives an indication of what passive income I can expect. So, for example, if I pick a share with a 2% yield versus one with a 6% yield, I’d only expect a third as much passive income.
Reasons for caution
When looking for high yield shares for my passive income list, however, I look to avoid “yield traps”. These companies have mouth-watering yields, but a change in business results or some other factor means the dividends would likely be cut. Not all high-yielding shares are yield traps, but many are. So I look for a company that can cover its dividends from free cash flow even in years when the business faces tough conditions. An insurer like Legal & General, with a fairly steady, predictable revenue stream appeals to me for that reason.
Finally, I have more than one share on my passive income list. Diversification helps to reduce my risk. It means I am not overly reliant on any one company, as even the best dividend payer can face unexpected misfortune.
