The idea of earning some extra income does not necessarily involve more work. A lot of people simply buy shares in well-known companies with proven business models then sit back and collect dividends on a regular basis.
Doing that now could help me earn passive income for the rest of my life. Here is how I would go about it.
Understanding dividends
The income comes in the form of dividends.
Dividends are basically one way a business can use spare money. Not all businesses have enough cash to do so, while others may decide to spend it on other things like expansion.
But a lot of companies do pay dividends. Indeed, some such as Guinness brewer Diageo (LSE: DGE) have increased their payout per share annually for decades.
Dividends are never guaranteed, though. On top of that, if I buy a share and it falls in value, by the time I sell it I may have lost more money than I earned in dividends from owning it.
The opposite is also true: I may buy a share for its dividend but have the happy experience of seeing it grow in value over the long term too.
A quick look at the share price performance of Diageo makes the point.
Looking for income shares to buy
So how do I try to find shares to buy?
I begin by looking for a business I think I can understand. Diageo’s brewing and distilling model fits the bill. I try to focus on firms I think have a large target market that is likely to endure. Here, Diageo still does well in my view, but there are risks. Younger consumers are drinking less beer and spirits than their parents before them.
That could pose a threat to Diageo’s sales volumes and revenues. Still, the market remains substantial and Diageo has also been growing a non-alcoholic offering with products such as Seedlip.
Next I look at the company’s balance sheet. Too much debt can mean an otherwise attractive business may be unable to pay me extra income in the form of dividends in future, even if it is doing so now.
Only at that point do I consider the company’s dividend yield.
High-yield focus in the UK market
While I like Diageo and would happily buy it for my portfolio if I had spare cash to invest, that would be because of its long-term growth prospects and business quality.
From the perspective of earning extra income, the yield of 3.1% is not especially exciting for me.
To hit my target of £70 per year for each £1,000 invested I would need to achieve an average annual dividend yield of 7%. Currently the UK stock market offers a number of blue-chip high-yield shares that would fit the bill, unlike Diageo.
I own some, such as British American Tobacco and M&G.
I also own one that fits the bill now but plans to cut its dividend in half – Vodafone. As I said above, dividends are never guaranteed so it pays to do the right research when building extra income streams!
