When it comes to earning money without working for it, Warren Buffett certainly knows a thing or two.
In fact, it was Buffett who said that, “if you don’t find a way to make money while you sleep, you will work until you die”.
That may sound dramatic.
But making money while you sleep – also known as earning passive income – can be a very powerful tool to build wealth even from modest beginnings. Buffett started with no money of his own except what he saved from his paper round – and is now a billionaire many, many times over.
By taking a few leaves from his book, I reckon I could potentially build massive passive income streams.
Look where the ball is going
Warren Buffett is a smart enough investor to know that a company’s current performance is not enough to justify an investment.
Instead, he looks at whether he thinks a company has what it takes to do brilliantly in the future – and whether that is reflected in its share price.
So the current dividend yield of a share is not necessarily an indication of what sort of passive income it might generate in future.
Instead, Warren Buffett looks at what sort of business advantages it enjoys and how its finances look. From that he can decide whether he likes the future income generation potential of a business. That in turn influences its ability to pay a dividend.
That has led Buffett to own Dividend Aristocrats like Coca-Cola and American Express, that have raised their dividend annually for decades since he purchased them.
The power of compounding
In fact, in his most recent letter to shareholders of his firm Berkshire Hathaway, Buffett pointed out that he spent $1.4bn on Coca-Cola shares back in the 1980s and 1990s. That holding now generates over $700m of dividends every year.
In other words, Buffett is getting half his original investment back every year as passive income – and still owns the shares, which incidentally have soared in value.
That shows the benefit of finding the right companies to invest in.
But it demonstrates another thing that has been critical to Buffett’s fortune-building.
What does Warren Buffett do with all those dividends? He uses them to make more investments that in turn will hopefully also generate large returns.
Aiming high
That is known as compounding.
When it comes to passive income, it can be tempting to start taking dividends as income immediately.
But if I wanted to build massive passive income streams, I would not do that. Instead, I would compound my dividends. By taking a long-term approach like Buffett does, that could let me generate larger earnings in future.
For example, imagine I invest £300 each month in shares yielding an average 8%. If I take the dividends out as cash, after 25 years I would be earning £7,200 annually.
But if instead I invested the same amount and compounded the dividends, after 25 years my portfolio would be able to generate almost £22,000 in passive income generally, if I decided to start receiving the dividends as cash.
Warren Buffett often emphasises the power of simplicity. I think building large passive income streams can indeed be simple. But it will not happen unless I take the right steps to make it happen!
