My approach to generating passive income does not rely on wacky schemes or unproven business ideas.
Instead, I am happy to buy shares in companies with successful business models I think can help them generate spare cash to fund a dividend for shareholders like me.
As an example, if I wanted to target a £1,000 annual passive income right now from a single FTSE 100 share, here is how I would go about it.
Buying the business not the yield
I should start by explaining that I would not put all my stock market investments in one share. That would give me no diversification – and even the best-run company can get into unexpected difficulties on occasion. So, this would be alongside the other existing investments in my Stocks and Shares ISA.
The share I am eyeing is actually one I already own, M&G (LSE MNG).
Something that grabs many people about this share is its juicy dividend yield of 9%. That could mean that, for every pound I invest, I would hopefully earn 9p per year, every year, in dividends.
But as dividends are never guaranteed, it can be a (costly) mistake to look at yield alone.
Instead, in my quest for passive income, I want to be comfortable understanding how a business works and what its financial prospects are.
Otherwise I could buy a value trap – a share with a high yield that then collapses when the company cancels its dividend. That is exactly what happened at Direct Line last year.
Long-term cash generation potential
M&G is in asset management, not insurance. Still, some of the risks that have proven a challenge for Direct Line also apply to M&G, in my view.
For example, although demand for asset management is high, meaning it can be a lucrative business, that also means there is a lot of competition. That can put pressure on profit margins. I reckon M&G has some competitive advantages that can help it in this regard, from its powerful brand to its long history in managing assets.
Just as was the case with Direct Line (as insurers seek to generate returns by investing money), weak stock markets could hurt M&G’s business. That is because when shares perform poorly, investors may be tempted to sell, reducing the asset manager’s scope to earn commissions over the long term.
Still, M&G has a proven business model and has proven highly cash generative.
Indeed, it has had enough cash to buy back hundreds of millions of pounds worth of its own shares in recent years, alongside paying the generous dividend.
Doing the maths and aiming for a target
M&G aims to maintain or raise its dividend each year. This year, for example, the interim dividend grew 4.8% compared to last year.
If I wanted to target £1,000 in passive income every year, I could buy 5,102 M&G shares. At the current price, that would cost me around £11,225. If I had spare cash to invest, I would be happy to do that.
In fact, if the final dividend grows at the same rate as the interim dividend, investing that could put me on track for over £1,000 in passive annual income.
Any future dividend increases could boost my earnings even more!