I regularly buy shares in the hope that they will pay me dividends to increase my passive income. But if I had a lump sum, say of between £15,000 and £20,000 today, here’s how I would try to target an average monthly income of £385 with it.
Not all shares pay dividends
Dividends are the main way companies share their profits with shareholders. The more shares I own, the more of a claim I have on the surplus earnings that are earmarked for distribution.
Of course, these payouts aren’t always guaranteed. A business might hit a rough patch and cancel its dividend to preserve cash. FTSE 100 banks did so during the financial meltdown of 2007-08. And Tesco did the same in 2016 and 2017 following weak profits and an accounting scandal.
Meanwhile, other firms that could easily afford to pay juicy dividends choose not to. In fact, looking at the top 10 largest companies listed in the US, I see 50% have never paid a dividend.
Avoiding potential value traps
Fortunately, hundreds of publicly-listed shares in the UK do pay dividends. Some of them have high yields, which means they offer above-average passive income opportunities.
However, I wouldn’t just go scooping up those with the highest yields.
Take Vodafone (LSE: VOD), for example. That’s a well-known stock with a gargantuan 11.6% dividend yield at present.
Yet it’s important to remember that the company is operating in a low-growth, capital-intensive industry (telecoms) with plenty of competition.
It also has a huge amount of debt, as well as a patchy dividend record.
Plus the yield is so high because the share price has been in decline for a very long time. As shares prices fall, yields go up, due to their inverse relationship.
A high yield isn’t attractive if a falling share price might ultimately lose me money!
To my mind, Vodafone stock is the quintessential value trap. But I may be thinking that way due to my own inability to identify deep hidden value. Perhaps the new CEO can reinvigorate the business and improve the share price.
Passive income goal
I’d focus on businesses that generate large free cash flows today but also have good future commercial prospects.
Ideally, I’d also want them to have a solid track record of increasing dividends. That doesn’t automatically mean the record will continue, but it’s something I do value.
Finally, I’d want to invest in a nice selection of shares across sectors to reduce risk.
With a monthly target of £385, my goal would be to earn £4,620 in passive income annually. But that would mean generating a 25% yield on my savings figure of £17,500 (the mid-point between £15k and £20k).
Obviously, that’s not a realistic yield to expect on my portfolio. Therefore, I’d have to take a long-term view to reach my desired figure.
One way to do this would be to initially reinvest cash dividends rather than take them out of my portfolio. This would trigger the compounding process.
Doing so, I could reach a figure of £57,871 after 15 years, assuming an average 8% return. This sum would pay me an average of £385 a month.
Of course, if I choose to invest more money along the way, I’ll potentially reach my passive income target many years earlier.
