Working for a living has its pros and cons. But whether or not one works, it can be possible to earn extra money without labouring for it. That is known as passive income.
One of my own passive income streams is dividends I receive from owning shares. Over time, I am hoping such dividend income can become sizeable. Here is how I would target a monthly average dividend income of £500 – without having to work for it.
Buying stakes in great businesses
Lots of shares pay dividends and lots do not. Some pay them now but will stop doing so in future.
When trying to generate income, it can be easy to get caught up in how much money one share might pay me each year compared to what I pay for it. This is known as the dividend yield. But simply buying shares that have a high yield now without understanding the business could leave me disappointed in future.
Instead, like billionaire investor Warren Buffett, I see shares as tiny slivers of a business. If I can find a great business in which to invest at an attractive price, hopefully over time it will be very profitable – and pay me passive income in the form of dividends.
Massive dividend flows
Buffett gives an example in his annual shareholders’ letter, which was published last weekend. From a commercial perspective, I see Coca-Cola as an attractive business. Its unique brand and proprietary formula give it a competitive advantage in a market with billions of possible customers. That translates into pricing power, which enables profitability and dividends.
As Buffett notes, his company spent seven years up until 1994 buying shares in Coca-Cola (they were cheaper then than they are now). The cost was $1.3bn, a lot of money! But last year, Buffett’s firm received $704m in Coke dividends.
Ignoring the huge sum Buffett invested, the shares now generate passive income of around 54% of what they cost, in just one year!
By investing in a successful company with a business that has let it grow its shareholder payout regularly, a long-term investor like Buffett is now reaping huge rewards. If I had invested at the same time but with a much smaller sum – even a few hundred pounds — I too would now be yielding over 50% a year on my initial investment as passive income.
Long-term diversification
I could have hit my target of £500 in dividends each month if I had invested a little over £11,000 in Coke shares when Buffett did.
Like Buffett though, I never put all my money into one share.
On top of that, the yield available to me over time may grow — but typically I would not expect to buy any shares today that yield more than around 10%. Even that is unusually high for blue-chip companies. Coke’s current yield is 3.1%, for example.
Setting up passive income streams
If I put £300 into a share-dealing account each month and invested it at an average 5% yield, I would take around 34 years to hit my target.
I could speed things up if I reinvest the dividends along the way, something known as compounding. Hopefully, my passive income streams could grow substantially if, like Buffett, I buy and hold attractively-priced shares of great companies.
