Dividends can form a useful passive income stream. Over time, by putting more funds into shares, I hope to increase my monthly dividend income.
Here is how I would aim to get to £250 a month within five years, by investing £1,000 per month on average.
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Aiming for a certain dividend income
A couple of variables will determine how much dividend income I can start to generate over time. One is how much money I put in. The other is the dividend yield of the shares I buy.
I cannot control the second factor. But the first – how much I invest – is up to me. If I decided to invest around £1,000 each month, that would let me invest about £12,000 each year in dividend shares. I say “around” because in practice, the exact amount may vary. Realistically there may be some months where other spending needs take priority. Equally, in some months I may have a bit more than £1,000 to put into dividend shares.
But if I can manage £1,000 a month on average, that would give me a £60,000 investment pot at the end of five years. If I invested in shares with an average yield of 5%, that should generate £3,000 each year in dividend income — £250 a month.
If I only invest £1,000 each month, it would take me time to build up to my target. But while I saved and invested, I could still earn some dividends. So I might not hit my monthly £250 target for five years, but I could start earning at least some dividend income within just a few months.
Choosing the shares
I would diversify across different shares and business sectors. That would help to reduce my risk in case things turned out worse than I expected for a share I bought.
Although it can be tempting to focus heavily on dividend yield, I would consider some other points when choosing shares for my portfolio. I would want to see how well dividends were covered by a company’s free cash flow, for example. Ultimately a company needs sufficient cash to pay dividends each year. Free cash flow figures could help me see whether a company has enough money to do that.
Additionally I would think about how a business may do in future. To set up dividend income streams for the long term, I would want to invest in businesses that seem to have the ability to grow their earnings as the years go by.
Two dividend income ideas I would use
An example of a company I would consider is consumer goods maker Unilever. Its portfolio of premium brands gives it pricing power. So although there is a risk that inflation could hurt profit margins, hopefully the company could increase prices to maintain its profitability.
Unilever yields 3.7%, below my target average of 5%. But I could compensate by buying some shares with a yield above 5%. For example, Legal and General yields 6.3%. So the average of this financial services company and Unilever should yield me 5%. I like Legal & General’s proven ability to generate sizeable profits: last year’s post-tax profit from continuing businesses was £1.3bn. One risk to profit margins is the impact of new UK rules on renewal pricing for insurance policies. But I think a strong brand and resilient demand for products such as insurance should help the company keep producing profits.