What is a genuinely passive way to generate passive income?
Investing in shares ticks the boxes for me. I can sit back and do nothing while hopefully the dividends roll in. Not only that, but over time, the value of a carefully-chosen share portfolio might increase as well (although it might not).
Let’s walk through the practicalities of how such an approach could work, imagining I had a spare £8,000 to invest. In fact, even if I had no spare money right now, I could still use this approach as I explain here.
Putting money in the stock market
My first move would be to set up a share-dealing account, or Stocks and Shares ISA.
I could put my £8,000 in it straight away. Or even with nothing at the beginning, I could start making regular contributions to it so I built a pot of money to invest.
Hunting for great dividend shares to buy
Next I would learn about the stock market and how to value shares. I would also learn about what sorts of companies might pay dividends and in what situations.
Only some companies pay dividends. These may be committed to increasing the size of the payout annually, like Halma. But no dividend is ever guaranteed.
So as well as an enthusiasm for the idea of paying dividends, I would also consider a firm’s likely ability to pay.
Understanding free cash flow
Financial analysis often considers earnings as a snapshot of how a company is performing.
I pay attention to earnings. But when it comes to dividends, what really matters is free cash flow. That is the money a company actually generates (or not) each year.
So for example, it may have strong earnings but need to use them to pay down the debt on its balance sheet.
Hunting for dividend shares with strong potential
Companies publish details of cash flows in their annual reports. Those are historical though.
To earn passive income, I want a business to continue generating large free cash flows and use them to pay dividends.
So I look for firms that have what I think it takes to generate the right sorts of free cash flows. Is there a large market of target customers? Does the company have a position in its market that somehow sets it apart from competitors? How much debt does it have on its balance sheet?
Having a target
The amount of passive income I earn depends on how much I invest and the average yield I earn. If I reinvest the dividends (something known as compounding), I could hit my target sooner.
Imagine I invest the £8,000 at an average yield of 8%, for example. Compounding the dividends, I ought to hit my monthly passive income target after 30 years.
Or I could choose not to compound and simply start taking out dividends from the beginning. At an 8% yield, my £8,000 should earn me £640 in passive income annually.
