Passive income is money gained without working for it. One of my favourite passive income ideas is buying shares in companies that pay dividends.
If I wanted to do that with a monthly target of £300, here are the five steps I would take.
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1. Learn about dividends
While it may sound obvious, I would want to know exactly what dividends are and why companies pay them out, or not. That would allow me to look at a firm’s business prospects and finances then evaluate how likely I felt it was to pay dividends in future.
Although it may sound obvious, a lot of investors do not do this. They simply look at what a company’s dividend was in the past and figure out how much they could earn if it continued to be the same in future. But past dividends are not necessarily a guide to what a company will do next.
To fund dividends, a company needs free cash flow. That is similar to profits but is not quite the same as a firm may sometimes book profits without the cash actually coming in to it. Even if a business is making high operating profits, it may not generate free cash flow. For example, if it has heavy borrowings, it may need to use all its available money to repay debts.
Learning how to spot what sort of companies will likely be able to pay and grow dividends in coming years is a useful skill for an investor. If I wanted to set up passive income streams, it is among the first things I would do.
2. Start saving regularly
If I wanted to target £300 a passive income each month, that would add up to £3,600 in a year.
Imagine that I seek to earn this by investing in shares that have an average dividend yield of 5%. To hit my target, I would need to invest £72,000. If I had that money to start with, I could invest it immediately.
But maybe the whole reason I want passive income streams is because I do not have much (or even any) spare money right now. In that case, I would try to build up to my target over time by putting aside a set amount of money each month to invest in dividend shares.
The more I can save each month, the faster I should be able to hit my target. I think getting into the habit of regularly putting aside money could help my self-discipline. That may make it easier to keep going even when other spending priorities pop up.
3. Get ready to buy shares
As I saved more money, at some point I would be ready to start buying shares. I would want to diversify my holdings as a way of reducing the overall risk to my portfolio if one of the shares in it turns out to be disappointing.
So I would want to set up some sort of share-dealing account, or Stocks and Shares ISA. Even if I do not expect to need it for a while. I would do this soon. That way, when I decide I want to start buying shares, I will be ready to make a move immediately.
4. Choose dividend shares to buy
With my improved knowledge of how dividends are funded, I would be ready to start looking for income shares that I could buy for my portfolio. To do this, I would follow some broad principles.
The first principle is that I would follow investor Warren Buffett’s advice and stick to my circle of competence. Looking down the list of FTSE 100 companies today, I can see some businesses I do not understand. For example, miner Glencore and real estate operator Segro both pay dividends, but personally I know little about their businesses.
I would stick to what I know, so unless I decided to spend time learning about those two firms, I would not even consider buying their shares for my portfolio. But I feel I understand companies like Tesco or Associated British Foods (ABF) so they would be on my consideration list.
Would I buy them though? The second principle I would follow is to look for companies that have some sort of competitive advantage I think could help them do well in markets I expect to see ongoing customer demand. Tesco’s branch network and brand give it this, in my opinion, just like ABF, which owns iconic brands like Twinings and value fashion retailer Primark. So I would consider both shares for my portfolio.
But whether I would buy them or now depends on the value they offer me. The price at which their shares trade helps me assess how much value these shares offer me and what their prospective dividend is. Right now, ABF’s dividend is just 2.1%. As my objective here is to generate passive income, that does not look too attractive to me. Tesco’s is better, at 4%.
Still, other shares I think also have good business prospects yield considerably more than Tesco. So even the supermarket giant might not make my shopping list. But although yield matters in my approach, I only look at it for companies I think have solid business prospects. Crucially, I am not just searching for high yields. Instead, I am searching for great businesses — and only once I have found them do I then consider their yield.
5. Invest for long-term passive income
Once I bought shares, I would sit back and let the dividends hopefully start rolling in. I would also keep saving money regularly. I would also keep an eye on how the companies I invested in were performing, in case anything happened to change my investment thesis about them.
But, crucially, I would not jump in and out of the market frequently. That is trading, not investing. And having found promising income shares to own, once I bought them I would hope to benefit from their dividend generation potential for years to come.