Working more hours to get extra income can be hard. There are only so many hours in a day and many people have more exciting things to do with them than work. That is where passive income comes into play.
One of my favourite sources of such effortless income is investing in dividend shares. Here is how I would do that with the aim of generating £250 a month — £3,000 a year!
Start with the end in sight
To figure out how much I would need to invest in dividend shares to aim for that level of passive income, I need to know what ‘yield’ I can hope to earn. Yield is basically the percentage of my purchase cost I would hopefully earn back in income each year. So, for example, Vodafone shares cost around £1.39 each at the moment. The annual dividend per share is around 7.6p. So the yield I would expect to earn if I buy Vodafone shares today is about 5.6%.
That is higher than the average FTSE 100 yield, but there are quite a few blue chip shares that offer a yield of around 5%. At that level, to earn £3,000 each year in dividend income, I would need to invest £60,000.
Putting my passive income plan into action
One reason I like owning dividend shares to generate passive income is that it is not an all-or-nothing plan.
If I can invest £60,000 today at a 5% yield, I could hopefully hit my monthly target of £250 in passive income fairly soon. But if I can only afford to invest a much smaller sum at first, I could start by doing that. I would not earn as much passive income, but at least I should earn some. Over time, if I can add to my investment pot, hopefully my monthly passive income could get closer to my target.
Learning about shares
Simply having the money does not earn me passive income, though. For that, I would invest it in dividend shares.
It can be tempting to go after very high-yielding shares in an attempt to maximise one’s passive income. But shares with a high yield sometimes come with elevated risks. Of course, remember that investments always involve various risks, and you may get back less than you put in. There is a risk of losing the capital invested.
So I would instead focus on a company’s likely future ability to pay out dividends. What are its free cash flows currently? Such information is available in a firm’s annual report, free online. Next, how likely is the company to be able to sustain such free cash flows? That is a matter of judgment not fact. But if a company has a sustainable source of competitive advantage that gives it pricing power, such as a famous brand or proprietary technology, I often take that as a good sign. I also look at a company’s net debt. After all, if it needs to spend its free cash flows servicing debt, there will not necessarily be anything left over to pay dividends.
Moving to next steps
Having found some shares that matched my investment criteria and risk tolerance, I would be ready to start investing. To reduce my risk, I would invest in companies across a variety of business areas. That way, if one of them of them underperformed my expectations or cut its dividend, the impact on my overall passive income would be limited compared to putting all my eggs in one basket.
