The idea of making passive income can often seem impossible. I get it. But through buying dividend shares, making a second income could eventually become a reality.
Minus the work I do pruning my portfolio, I’ve been snapping up stocks that reward shareholders with handsome payouts and simply tucking them away into my holdings. The plan is to leave them there for years and let the cash pile up.
If I had £20,000 sitting in the bank, I’d put it to work. Here’s how.
Due diligence
There are a few important things I always look for when doing my due diligence. I like to target large businesses with proven business models. That’s why I love the FTSE 100.
I also like businesses with stable cash flows. This means they have the resources to keep paying dividends. Hopefully, it also means the payout will rise over the years.
Finally, I target stocks that have a yield higher than the Footsie average, which is 3.6% as I write.
One I own
For example, a stock I own and would happily buy more shares of today if I had some cash lying around is British American Tobacco (LSE: BATS). Let’s see if it ticks all the boxes I mentioned above.
Firstly, does it have a proven business model? Yes. The market British American Tobacco operates in is huge and it’s one of the largest players in the field with premium brands under its umbrella such as Lucky Stripe. Last year, the firm sold over 555 billion cigarettes.
Does it have stable cash flows? Yes. In 2023 it generated around £10bn in free cash flow. It expects to generate around £40bn over the next five years.
Does it have an above-average yield? Yes. The stock yields a whopping 9.4%, the third highest on the FTSE 100.
The risks I see with the business is that smoking is a habit that’s becoming less popular and the industry is coming under more scrutiny.
However, the company is diversifying by investing in its division that sells non-combustible goods. It’s made good headway so far.
Putting it to work
That 9.4% yield could earn me £1,880 a year from my £20,000. I could pocket that and spend it on bills or a luxuries. But there’s another option.
If I reinvested the dividends I received to benefit from ‘dividend compounding’, I could grow my nest egg much more quickly.
By doing that, after 30 years I’d hopefully make £29,664 in passive income. My investment pot would be worth £331,870.
That sort of money would set me up for a much more comfortable retirement. And I could make that just by investing my lump sum, leaving it, and letting the stock market work its magic.
If I decided I wanted to invest a further £100 a month, by year 30 I could in theory receive £47,398 in passive income.
Time in the market
This example doesn’t account for a change in British American Tobacco’s yield. While I’m hopeful it will at least be sustained or rise, it could fall or be cut completely. There’s always that risk with dividend-paying companies.
However, what it does prove is that targeting stocks with thumping yields and being patient can be an incredibly effective way to build meaty streams of passive income. It’s how I plan to build my wealth over the decades to come.
