Whether it’s an emergency fund or holiday savings, any amount of spare cash could be used to earn passive income. As the saying goes: “Give every dollar a job“.
Essentially, this means that money should be put to work rather than left gathering dust. Savings accounts seldom pay more interest than the inflation rate so any money left in one is usually losing value.
Investing in the stock market provides a chance to beat inflation and harness the power of compound returns. But it also comes with the risk of losing money. So it’s important to pick the right stocks.
Dividend shares
A popular method of earning passive income is by investing in dividend shares. Unlike growth shares that rely on a rising price to generate value, dividend stocks promise regular returns. This makes it easier to build a portfolio that provides a reliable income.
But dividends aren’t guaranteed. So it’s important to look for a company with a track record of consistent payments.
For example, consider British American Tobacco (LSE: BATS).
The tobacco giant’s share price has fallen 49% since 2017 due to changing opinions on smoking. New health regulations have led to declining sales, forcing the company to adapt or die. However developing less harmful, smoke-free tobacco alternatives is a costly endeavour.
Dividend-wise, it ticks the most important box as it has almost three decades’ worth of consistent, uninterrupted payments. Another important factor is the yield, which determines the percentage paid as dividends per share. The higher, the better.
The stock’s yield is currently around 8%, which is much higher than the FTSE 100 average. A £5,000 investment would return £400 in dividends a year. If the dividends were reinvested and held for 10 years, the pot could grow to £17,340 and pay £1,260 in annual dividends (assuming an average annual price gain of 5%).
However, the yield fluctuates with the share price so it shouldn’t be considered too important. A reliable payment history is the key factor to look for.
Other considerations
Of course, investing in a stock simply because it has a good dividend history doesn’t guarantee returns. If the company’s on the brink of failure, it could all go down the drain. By looking at the company’s balance sheet and income statement, we can evaluate its financial stability.
British American is well-established, with a £63bn market-cap and £28bn in revenue last year. But the cost of transitioning to less harmful products left it unprofitable at the end of 2023, with a £14bn impairment.
Recent half-year results show some improvement, with £4.4bn in earnings despite an 8.2% drop in revenue. If the transition to next-gen smokeless products pays off, it should keep doing well. But it remains a significant risk.
Diversification
There are several other dividend stocks to choose from that may have a more reliable business model. The trade-off being that they usually pay a smaller dividend. For example, pharmaceutical firm GSK has a very solid business model but only a 4% yield. Or utilities firm National Grid, with a 4.4% yield.
I think it’s important to build a diversified portfolio that includes several stocks from various sectors. This can help to ensure stability while also taking advantage of the potential returns that high yields offer.
