One way some financially savvy people earn passive income is by regularly investing money into shares that pay dividends.
I like that approach for a number of reasons. It is simple, allows someone to benefit from the hard work of successful companies, and can be adapted to each person’s own financial circumstances.
For example, imagine someone starts doing this aged 21, with £60 a week. Here is what they could be earning by 35.
The magic of compounding
One approach would be to invest the money and receive any dividends along the way.
Personally, I prefer a second approach, which involves reinvesting those dividends (known as compounding).
Compounding at an annual rate of 7%, the portfolio ought to be worth over £72,600 by 35. At a 7% dividend yield, that could generate around £5,083 of passive income each year.
I think 7% is a realistic target in the current market while sticking to carefully selected blue-chip shares.
How to start investing
Dividends are never guaranteed. Compound annual returns can be affected by share price moves too – prices can down as well as up. So, careful selection of a diversified portfolio of quality shares is the order of the day.
Before getting onto that, though, it is necessary to have somewhere to put that £10 each week.
So a useful, practical first move to put this passive income plan into action would be to set up a share-dealing account, Stocks and Shares ISA, or trading app.
Finding brilliant dividend shares to buy and hold
Another important step – and one I think it is well worth taking time over if necessary – is looking for income shares to buy.
What makes for a good income share?
Different people have their own ideas, but I think it is helpful if a company has a proven ability to generate more spare cash than it needs. So, it can be helpful for a company to have a mature business that does not require very high ongoing investment.
An example of such a company I think investors should consider is British American Tobacco (LSE: BATS).
The Lucky Strike maker has long been a massive cash generator. Cigarettes are cheap to make but can be sold expensively – and it sells millions every day, around the world.
The dividend yield stands at 6.6%. British American is one of the few FTSE 100 companies to have raised its dividend per share annually for decades.
No dividend is ever guaranteed, though. Cigarette use is declining in many markets and that poses a risk to profits for British American. Whether it can keep its cash cow generating lots of spare cash in coming decades, while building its non-cigarette business, will be critical when it comes to the firm’s long-term performance. That will matter for many investors’ passive income plans.
For now, at least, British American’s brand portfolio, multinational operations, and large customer base mean that it continues to generate sizeable free cash flows.
