There are lots of different ways people try and earn passive income. By investing in blue-chip companies with proven business models and strong potential cash flows, I hope to build passive income streams in the form of dividends.
Dividends are like a form of profit sharing. Companies do not always generate enough spare cash to pay them and, even when they do, may decide not to. So dividends are never guaranteed.
But with careful selection of well-known shares to buy, I think I could set up meaningful passive income streams.
Using a lump sum to invest
As an example, imagine I had some spare cash I decided to tuck away in dividend shares. In this example, I will refer to £9,000. But in fact I could use whatever amount was available to me using the same investment principles, though the size of my dividend income would vary accordingly.
My first move would be to set up a share-dealing account, or Stocks and Shares ISA. I would add my £9k, then start looking for shares to buy.
Finding income shares to buy
I would follow some basic principles when hunting for shares. Rather than risk everything with a single company (never a good idea, in my view), I would diversify my holdings by spreading the £9,000 evenly across a few different shares. Five to 10 should suit me fine.
I would look for shares with an already proven business model, positive free cash flows and a track record of sizeable dividend payments. But past performance is not a guide to what might happen in future, so I would also look at whether I felt a given company had strong future dividend prospects.
By the way, successful stock picking is not just about what you buy but also how much you pay for it. So even though my passive income plan focuses on dividends not share price gain, I would also always consider the valuation of shares when I bought them.
One dividend share I’d buy now
As an example, let me share one FTSE 100 share I would happily add to my passive income portfolio today, if I had spare cash to invest, namely Legal & General (LSE: LGEN).
The company operates in a market with sizeable, long-term customer demand. It has some competitive advantages that help set it apart, such as a well-known brand, deep financial markets expertise and large customer base. It has a proven business model and the current dividend yield is 8.1%.
One risk I see is wobbly financial markets leading to weaker returns and some of Legal & General’s clients pulling out funds, hurting profits.
Cranking up the income machine
Still, even if I could achieve an average dividend yield of 8.5% on my £9,000 – slightly higher than Legal & General offers and over double the FTSE 100 average – in a year that ought to earn me £765 in passive income. That would be welcome, but is a far cry from my £5,880 annual target.
For that, I would simply keep reinvesting the dividends. Compounding at 8.5% annually, after 25 years my £9,000 ought to generating £5,880 in passive income annually.
