When it comes to passive income, I think sometimes simple can be best.
Sure, I could aim to set up a business of my own and then hope to earn money without doing anything for it. But lots of other people already run very successful, proven businesses.
By putting some money into buying shares in such businesses, hopefully I could earn passive income in the form of dividends.
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Putting money to work in the stock market
To illustrate the principle, imagine I had a spare £8,900 I was able to invest. Everyone’s financial circumstances are different, but the broad principles below apply even for a different amount.
I would want to invest that in shares that I think could pay me part of their spare cash flows in future, in the form of dividends.
Shares that have paid dividends before can stop paying them and businesses that have prospered before can hit hard times. So I would diversify my £8,900 across a few different shares.
Before doing that, though, I would need a way to buy and sell shares. So I would start by setting up a share-dealing account or Stocks and Shares ISA.
Finding shares to buy
With passive income as my objective, I would want to reduce the risk of buying shares that stop their dividend. So I would pay close attention to what I was investing in.
An example of the sort of income share I would buy is Dunelm (LSE DNLM), one I do not currently own but would be happy to buy if I had spare cash to invest.
The reasons I like the passive income prospects of Dunelm help show what I look for.
First, I look for a market I expect to benefit from strong and sustained demand. I think that is true of the homewares market in which the retailer operates. Next, I look to see whether a company has a competitive advantage that can help set it apart. Dunelm’s store network and unique own-label products tick that box for me.
But remember I want proven businesses, not just promising ideas. Dunelm again fits the bill. It has been consistently profitable, earning £152m last year. That was a fall from the prior year. An ongoing risk I see is a weak economy leading consumers to cut back on non-essential household purchases, hurting sales and profits for Dunelm.
At 14 times earnings, I see Dunelm shares as reasonably valued. The dividend yield is 4%. But the company often pays special dividends alongside the ordinary ones used to calculate that yield. Last year’s dividends per share are equivalent to 7.9% of the current share price.
Taking a long-term approach
Even if I could invest all £8,900 across a diversified portfolio of shares averaging a 7.9% yield (well above the FTSE 100 and FTSE 250 averages), that would earn me £703 per year.
That is well short of the £3,360 I would need annually to hit my monthly passive income target of £280.
But as a long-term investor, my approach would be to reinvest the dividends.
If, by doing that, I could compound my portfolio at 7.9% each year, after 20 years I should hit my goal.
