It goes without saying that I’d like to buy shares when they look cheap. Overpaying for a stock limits my potential profit and can reduce my dividend yield. This is great in theory, but putting it into practice in the real world, with a strategy focused around generating me passive income for decades to come, is more complicated. Here’s how I’m trying to do it.
Finding the right stocks
To begin with I need to have a strict filter to get rid of any stocks that aren’t what I’m looking for. My strategy is focused on building income via dividend payments. So I want to cut out any company that historically hasn’t paid out dividends to investors. Even if such companies are cheap based on valuation metrics, it doesn’t matter to me.
Another addition to my filter is to focus on companies with a strong track record of dividends. This will serve me well for long-term investing. A high dividend per share payment today is great, but what about the consistency of this payment in 2030? It might seem a long way away, but I want to build income for life.
Bringing it all together, my sweet spot is buying shares that are cheap (that is, with a low price-to-earnings ratio) and also have a good history of dividend payments.
Why I’m trying to get set for life
Over time, I’m aiming to profit from two specific areas. The first one is the advantage of locking in the current dividend yield. Let’s say that I feel a stock is undervalued at 100p and feel it could eventually trade at 150p in years to come. It currently pays out a dividend per share of 5p.
If I buy now at 100p, my yield is 5%. Going forward, the only variance in the future dividend yield is if the dividend per share changes. If I assume this stays the same, but the share rises to a fair value of 150p, the future dividend yield drops to 3.33%. Therefore, buying now helps to lock in a better yield. And if the yield rises along with the share price, that’s even better for someone like me who bought at a lower price.
The second avenue of potential profit comes from my capital appreciation. If the above example does jump from 100p to 150p, I’ll have gained 50% on my original investment amount. I can use this as income, by trimming down some profits into cash.
This helps me get income for life, as both sources of profit will take years to accumulate and play out.
Risks to be aware of
I’ve tried to make my strategy as practical as possible, cutting out the theory. In doing this, I need to accept potential risks. A big one is that no one can predict the future. I might buy a stock now that underperforms in the future. This could see the dividend cut and the share price fall. This could result in a loss both on my capital and also a lack of income from no dividends.
I’ll aim to reduce this risk by investing in a portfolio of shares. That way, if one does go bad, it won’t have a material impact on my overall income stream.
