Buying 1,250 shares of this FTSE 250 stock could earn me a £1,000 passive income annually

Our writer looks at a FTSE 250 share with proven cash generation potential that raised its interim ordinary dividend this week. Here’s why he’d buy!

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Buying shares to earn passive income is a time-proven strategy to earn extra money without working for it. That is true not only of FTSE 100 heavyweights like Diageo and British American Tobacco (both of which have raised their dividends annually for decades). There are also some FTSE 250 shares with income prospects that grab my attention.

It might not always work as planned: a company can suddenly cut its dividend and so dry up as a source of passive income. But when it works well, it can work very well.

A proven business throwing off bucketloads of spare cash can sometimes pay juicy dividends year after year.

7.3% yielder

One such share is currently set to generate a 7.3% yield this year by my reckoning. That is based on it raising its final dividend at the same rate it boosted the interim payout.

The FTSE 250 share in question is homewares retailer Dunelm (LSE: DNLM). The business announced its interim results this week. On the dividend front at least, they were mixed.

The interim dividend per share grew 6.7%. The company also announced a special dividend of 35p per share. That is a chunky special dividend, but is lower than the 40p per year seen last year.

A special dividend can be a good way for a company to smooth out ups and downs in cash flows when it comes to setting a dividend level. It allows a company to increase the ordinary dividend smoothly over the course of years, while returning additional surplus capital to shareholders in the form of a special dividend that may move both up and down.

Why I like the business

What really matters to me when considering an investment, though, is how I assess the commercial prospects. After all, what happens to the dividend in future ultimately depends on how the business performs.

Revenue at Dunelm in the first half grew 4.5% year on year. As well as its network of shops, digital channels continue to grow in importance for the business and now account for 36% of revenues.

Pre-tax profit grew 4.8% to £123m. Free cash flow fell 11% to £91m. The ordinary and special dividends are set to cost the company £103m, so Dunelm is funding the dividend using all its free cash flow from the period, as well as eating into its existing cash pile.

The strong results underline some of the retailer’s strengths. It seems to understand well what its customers want and has various unique ranges of products to attract them. It is combining online and offline sales channels to good effect.

I’d buy

There are, as always, risks to be considered.

A weak housing market could encourage existing homeowners to spruce up their living space, but on the other hand it might lead to a general slowdown in homeware sales that hurt revenues.

But I think the business has good prospects and reckon it could well generate sizeable free cash flows to fund future dividends.

If the full-year dividend comes in at the 80p per share I expect, buying 1,250 of this FTSE share today ought to set me up for £1,000 in annual dividends. If I had spare cash to invest now, I would be happy to do that.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

C Ruane has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. and Diageo Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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