Earning passive income from dividend shares doesn’t require huge amounts of cash. Investing £1,000 each month over a long time can result in a portfolio paying £32,000 per year after 30 years.
That sort of outcome requires an average annual return of 4.5%. And while I think that’s highly achievable, there are some risks investors need to keep in mind.
Not all dividends are equal
On the face of it, a 4.5% annual return from dividend stocks is easy. Shares in British American Tobacco (9.5%) and Legal & General (8%) currently come with much higher dividend yields.
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The issue, though, is that these companies operate in risky industries. Smoking appears to be in decline and underwriting profitably in the life insurance business is extremely difficult.
In both cases, there’s a danger the businesses might not be able to maintain their dividend payments over the long term. And investors know this, which is why the stocks trade with high dividend yields.
The market isn’t infallible, though. Sometimes a stock might trade with a higher yield than it should because investors think it’s riskier than it is – this is where opportunities come from.
BP
I think BP (LSE:BP) is a good example of this. Right now, the stock comes with a 4.5% dividend yield, which is significantly higher than the 3.75% yield investors can get from Shell.
It’s also worth noting that there’s more to BP from a passive income perspective than meets the eye. In addition to paying a dividend, the company is currently spending money on share buybacks.
This reduces the number of shares outstanding, meaning the firm can maintain its dividend per share while paying out less in total. Since 2019, BP has decreased its share count by around 2.7% per year.
If this continues – and I think it can – the firm could well distribute more than 4.5% per year in dividends over the next 30 years. And this could make it a very valuable source of passive income.
Risks
The global drive to reduce carbon emissions by 2030 (and eliminate them by 2050) is the biggest risk BP faces. And the danger isn’t just the possibility of declining demand for oil.
Attempting to transition to renewables has been challenging for the company. Its investments in offshore wind generation have largely been unsuccessful and its mistakes have been expensive.
There’s reason to think this is changing, though. BP is shifting its strategy to focus on areas where it has a more obvious competitive advantage, such as charging infrastructure and hydrogen power.
This should benefit shareholders in both the near future and the long term. The company isn’t backing away from the energy transition, but it’s looking to be more careful about where it invests.
A stock to consider buying
BP shares come with a much higher dividend yield than Shell. But I don’t think the underlying business is significantly riskier.
While BP has had difficulties in figuring out a strategy for participating in the energy transition, the firm now seems to be on a better path. And this makes it look attractive at today’s prices.
With a 4.5% yield supported by ongoing share buybacks, I think the stock looks like a good option. If I were starting a regular investing journey with £1,000, I’d buy shares in BP.
