Getting money without working for it appeals to many people more than the prospect of the daily grind decade after decade. That is why the idea of passive income has become more popular over recent years. One of the passive income plans I use is investing money in dividend shares. I do not need to do the work myself, but can benefit if large companies such as British American Tobacco continue to pay out meaty dividends.
But even though such a plan can be fairly simple to put into action, I think a few things can help improve my chances of long-term success. Here are five key points.
Dividend growth might not mean big dividends
Imagine that one company is growing its dividend at 1% annually, while another is putting in double-digit percentage rises and just increased its annual payout by 20%. Which is the better income option for me?
At first glance, the answer may seem obvious. But let me now share some more information with you. The first company – Imperial Brands – is currently yielding 8.3%. The second business in my example – Judges Scientific – has a dividend yield of 0.9% at the moment.
Even if Judges keeps increasing its dividend by 20% annually – which is unusual – I calculate that it would take 21 years for my total dividends from Judges to match my collected earnings from the 1% raiser Imperial.
That said, dividend yield is not a good basis for investment decisions on its own, in my view. I am more interested in how healthy an underlying business is and what that means for the prospect of future dividends. But what this example does remind me is that, just as I do not consider dividend yield on its own, I also should not pay too much attention to dividend growth on its own either. A fast-growing dividend can still stay small for years if it starts small.
Reinvesting income helps compounding
When starting out on a passive income plan, a lot of people focus on the appeal of getting regular cash without working for it.
I think that makes sense – but it is not the only way to think about a passive income plan. It is also possible to reinvest some or all of the dividends in buying more shares. This could be a regular thing, or an occasional one, depending on how much cash one wants in any given month.
The benefit of doing that is compounding. Not only would the money I put aside for my plan be earning dividends, I would also be putting the dividends to work in buying additional shares. Over time, that ought to allow me to earn even more passive income.
Time works in my favour
If I am investing in high-quality companies as part of my passive income plan, over time I ought to benefit more and more. That is why I think the best time to start a passive income plan is now — or at least as soon as possible. The more time one has for the dividend shares to do their work, the better the long-term results will hopefully be.
Let’s take Diageo as an example. I could have bought it this week at a price of £39.30 per share. At that price, Diageo’s dividend of 72.6p yields 1.9%. But five years ago, I could have bought Diageo at £22.08 when its dividend was 59.2p per share. If I had bought then, my shares would now be yielding 3.3%. A decade ago, when Diageo was paying 40.4p per share in annual dividends, I could have bought the shares for around £15 apiece. If I had bought then, my current yield would be around 4.8%.
In other words, if I had bought this high-quality share and simply held it as part of my passive income plan, I could now be benefiting from a much higher dividend yield than if I bought the same share today. Things do not always work that way, of course. Share prices can fall and dividends may be cut. But if I invest in solid businesses at attractive prices, over time I would hope that taking a long-term approach would help boost my passive income significantly.
Dividends need free cash flow
Some investors do not like to get into the nitty gritty of reading a company’s accounts. But without doing that, I think it is difficult to understand how likely a company is to keep paying dividends in future. That is because a company can be very successful at selling its products or services but still lossmaking, for example because of ill-advised expansion.
Earnings help me understand how a company is doing. But they are an accounting measure. To pay dividends, a company needs money. I think the best measure for that is what is known as free cash flow (FCF). If a company does not have much FCF for a few years in a row, it will struggle to pay dividends. So when looking at ideas for my passive income plan, I always look for evidence of robust cash flowing through the business.
No passive income plan is perfect
If I invest in a share for its juicy dividend only to see it cut, it can be disappointing. Even worse, I may invest in a high-flying dividend payer only to see a dividend cut lead to a share price tumble. Not only will it no longer earn me passive income, I may not be able to sell the share at the price I paid for it.
Unfortunately, such disappointments are part of investing. One way I aim to deal with them is by diversifying my passive income picks across a range of businesses. That way, if one does worse than I expect, the overall impact on my portfolio will be reduced.
But I also focus on finding companies I think have a good chance of paying and increasing their dividend for many, many years to come. I may not be able to eliminate disappointments or mistakes altogether from my investing. But by spending time to find really great investment ideas, hopefully I can reduce them.
