Passive income ideas are not thin on the ground. But a lot of them do not suit what I want. Some need lots of money upfront, like buying property to rent. Others are not truly passive.
That is why one of my favourite passive income ideas is buying shares that will hopefully pay me dividends. Here is how I could do that starting today with nothing, using a spare £2 each day.
Dividend shares as passive income ideas
Dividends are basically surplus profits a company divvies up among its shareholders. Not all companies pay dividends. Sometimes a company’s business results change and it decides to cut its dividend. An example is housebuilder Persimmon, which announced this week that it will not pay a special dividend this year despite doing so last year.
A company might also be massively profitable but choose to keep excess cash inside the business rather than pay it out to shareholders. That is the situation at Google parent Alphabet.
With the objective of generating passive income, I would therefore need to identify firms I think are likely to make profits in future and pay out beefy dividends to shareholders.
Finding shares to buy
How can I find such companies?
I would focus on business areas I understood as that would help me assess a company’s prospects. If a business can benefit from long-term customer demand by providing a product or service that sets it apart from competitors, that could be the basis of future profits.
But such a firm may still decide not to pay out dividends, like Alphabet. So I would also consider its balance sheet and dividend policy. The balance sheet matters because even a profitable company may not pay cash out to shareholders if it is heavily indebted.
Valuation matters
But finding a great business is only part of my approach. I also consider whether its current share price offers me good value. So I think it is important to learn how to value shares.
As a long-term investor, my results will be better if I avoid overpaying for shares. Buying shares at an attractive price will also boost my passive income streams — perhaps dramatically.
Consider Direct Line as an example. Its current annual dividend is 22.7p per share. If I had invested £1,000 when the shares hit their 12-month high price of £3.13, I could have bought 319 of them. That ought to generate around £72 in annual dividends. But investing £1,000 when the Direct Line share price hit its 12-month low of £1.72 would have bagged me 581 shares, earning almost £132 in annual dividends.
Starting small
I could set up such passive income streams with whatever funds I have available. Putting aside just £2 a day into a share-dealing account would add up to £730 a year I could invest. I would spread my investment across a diversified range of companies to reduce the risk if one of them performs poorly.
Putting that much money into shares with an average dividend yield of 5% should earn me around £36.50 a year. In the second year, I could still earn dividends from shares I bought in the previous year – as well as buying new ones. In this way, hopefully I could set up passive income streams that last for decades.
