One practical way I aim to earn passive income is by investing in dividend shares. They are basically shares that I hope will pay me a regular dividend as a shareholder.
Buying shares to target dividend income
As such, shareholder payouts are never guaranteed, so I need to select carefully when buying shares in the hope of earning passive income.
Dividend yield is the annual dividend expressed as a percentage of the price I pay for a share. But these are never guaranteed, so a high yield today does not necessarily mean I will earn the rate of return I hope for in future.
Instead of focussing on current yield, I look at a firm’s business model and likely free cash flows. Based on that, I assess what I think its likely future dividend potential might be.
Buyers’ market
In many ways, I think the London stock exchange currently offers me a buyers’ market if my goal is to invest in blue-chip companies I think have strong income potential.
Consider some of the shares I have bought for my portfolio so far this year.
Legal & General and British American Tobacco both yield over 9%. Vodafone yields over 10%. Yet all three are well-known FTSE 100 companies with what I see as strong businesses.
That said, they all also face risks, which might be one reason why their yields are unusually high. That inherent risk in all shares helps explain why I own all three of these picks, rather than simply plumping for one of them.
Setting a target
What of my goal of earning £300 in annual passive income after three years, by investing three pounds a day?
To do that would require a couple of steps. One would be achieving the right average dividend yield. Another would be using my dividends to buy more shares.
If I could earn an 8.5% yield and then reinvested the dividends as I earn them, after three years I ought to be earning a little over £300 annually in passive income.
Compounding and portfolio growth
That simple step of reinvesting is known as compounding. It means I would not actually earn passive income in the first few years while I compounded dividends. But by doing so I should be able to buy more shares than I could manage with just the £3 a day I was putting aside.
In that way, by making some short-term sacrifice, hopefully I could build bigger passive income streams in future while still only investing that £3 a day.
Getting started as we mean to go on
If that plan sounds relatively straightforward, I think it is because it is!
But a crucial step, as well as the discipline of regular saving, is to choose carefully what dividend shares to buy. That will help determine whether or not I could hit my passive income goal.
