I like investing in dividend shares as a way to earn money without having to work for it. If I wanted to target extra monthly income of £300, here is a three-step passive income plan I could use.
Step one — the money
Using this passive income plan, to make money will take money. But fortunately I do not need a large amount to start with. Unlike some passive income ideas such as buying rental properties, I can start buying dividend shares with a small amount of money and build up from there.
So I would target a regular saving amount, either weekly or monthly. I would challenge myself to make this big enough that it can soon add up to a growing investment pot that can help me earn dividends. But I also need to be realistic. If I set too high a target and then do not keep hitting it, I may lose enthusiasm and abandon my passive income plan. So I would choose an amount to save each time that I felt was challenging but achievable.
An alternative would be just to save what I could when I could. So why would I set a target? It is because there are so often unexpected demands on one’s cash popping up. Just putting aside my spare money each month does not really force me to be disciplined about the investment habit. By setting a target, I would sometimes need to focus on hitting it. I think that disciplined focus could help me stick with my passive income plan and put it into action.
At some point I will use these funds to buy dividend shares. So I would put my regular savings in a share-dealing account or Stocks and Shares ISA.
Step two – the investing
As my funds grew, I would start thinking about how to invest them. After all, dividends are at the heart of my passive income plan but I will not earn them if I do not invest in shares.
There are lots of shares available – how on earth could I know where to start?
I think a good approach is to think like famous investor Warren Buffett and see a share as a tiny sliver of a business. I would not think about buying a business I did not understand. In the same way, I would only consider buying shares in businesses I felt I could understand. That is because I need to understand a business to have a better chance of assessing its likely future business and dividend prospects.
That understanding could be because I use the company as a customer, such as JD Wetherspoon or Tesco. Or it might come from professional experience I have working in an industry. But it can also be learned. For example, I may decide that hydrogen energy is a possible growth area but do not understand it. I could do my research and learn about the industry. That would help me assess the likely prospects of hydrogen energy companies such as AFC Energy or ITM Power.
How would I choose which shares in these areas might be good picks for my own portfolio when it comes to their passive income potential? A common starting point is looking at current or past dividend history. For example, British American Tobacco yields 6%. That means that for every £100 worth of British American Tobacco shares I buy, I would hopefully earn £6 a year in dividends. The problem with focussing too much on yield is that it is basically backwards-looking. Knowing what British American Tobacco paid in dividends last year does not help me much if I only buy the shares now. What will matter to the success of my passive income plan is the dividends that any shares I own may pay in future.
That is why I would start learning how to read a company’s annual report and accounts. That may sound boring but I think it is important work for an investor to do. As Buffett says, “unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself”. If I can start to understand what a company’s accounts mean, I can decide whether a good business could also be a rewarding investment for me.
To pay dividends, companies need to generate spare cash. So I would want to learn how to read a cash flow statement and balance sheet. From that, I would be able to make my judgments about how likely it is that a company might generate surplus cash over the next few years that it could use to pay dividends.
Still, I could make some choices that turn out to disappoint me. An unexpected development might suddenly lead to a company suspending its dividend, no matter how many years it had paid it before. That is why I would also diversify my investments across a range of companies and business sectors.
Step three – the passive income
The third step of my passive income plan would be generating the income from dividends once I had purchased shares.
How much I would expect to receive depends on the amount I invest and the dividend yield. Imagine I wanted to target £300 a month in passive income, for example. If I invested in shares with an average dividend yield of 6% like British American Tobacco, I would need to invest £60,000. If I was saving and investing money gradually, I would take time to build my passive income up rather than expecting to hit the £300 monthly target straight away.
But one key principle I would follow is not simply to chase yield. I would want to find high-quality businesses I thought had strong future dividend potential. Forgetting that and just putting money into the highest-yielding shares would risk me falling into what is known as a yield trap. That is a share with a high dividend but also a large risk of cutting the payout in future.
Putting my three-step passive income plan into action
The theory behind this passive income plan seems quite straightforward to me. But if it stays as theory, my passive income streams will not grow at all.
To try and hit my target, I need to put the plan into action. I could start today with even a fairly modest amount of money, as the first step of regular contributions.
