One of the masters of earning income without working for it is billionaire investor Warren Buffett. His company Berkshire Hathaway generates millions of pounds each month in passive income, thanks to the dividends it receives from companies in which it owns shares, like Apple and Coca-Cola.
The principles applied by Buffett could help me build my own dividend income streams even on a far more modest basis.
If I wanted to target an average monthly income of £1,000 by investing in blue-chip shares using Buffett’s principles, here is what I would do.
Buying quality businesses not high yields
Some of the shares owned by Buffett have high dividend yields. Others have low yields. Some pay no dividends at all.
He does not shop for shares purely on the basis of their yield. After all, no dividend is guaranteed, so a high yield today could turn into a zero yield tomorrow. We saw that this year when Direct Line abruptly cancelled its previously meaty shareholder payout.
So how does Buffett go about building his share portfolio? In short, he focuses on building a diversified portfolio of shares in what he sees as outstanding businesses that sell for an attractive price.
Hunting for income
Over time, hopefully a great business will grow in value. That could help me increase the worth of my shares.
However, that on its own does not necessarily equate to passive income. Take Apple as an example. It generates huge cash flow and has grown its dividend a lot in recent years. But it yields a meagre 0.5%.
Some of Buffett’s other holdings have a higher yield. Bank of America, for example, yields 3.4%.
So when building a portfolio, not only would I be looking for a company that could generate substantial free cash flows, I would also pay attention to how likely each firm seemed to use those largely to fund dividends.
Putting cash to work in other ways like research and development, or building a strong balance sheet, can help create long-term corporate value. But it does not necessarily translate into dividend income in the short term.
Aiming for a target
If I wanted to target an average monthly income of £1,000, that would be £12,000 each year. To earn that owning shares yielding 3.4% like Bank of America would require a portfolio worth around £353,000.
But even though I could use the Buffett method of investing, that does not mean the shares that are right for him would suit me.
If I could hit twice that yield – as I currently do from what I see as high-quality FTSE 100 shares in my portfolio such as Legal & General – I could hopefully reach my income target by investing the smaller sum of around £175,000.
I could do that as a lump sum if I had spare cash.
Or I could build up to it for example by investing £250 each week into a Stocks and Shares ISA and compounding my dividends. At an average yield of 7%, for example, hitting my passive income target ought to take under a decade.
