One simple but common way to earn passive income is to buy shares that pay dividends.
Dividends are never guaranteed, so this is not a surefire scheme. But I think it is possible to set up passive income streams with a fairly high sense of confidence in them lasting – by buying a diversified mix of shares in high-quality companies.
To illustrate, if someone wanted to target £10,000 a year in passive income, here is how they could go about it.
Getting ready to invest
One practical step upfront would be to set up a way to actually buy dividend shares.
To that end, the investor could look into options for a share-dealing account, Stocks and Shares ISA, or trading app.
Looking for shares to buy
I mentioned above the idea of buying shares in high-quality companies that look promising when it comes to future potential passive income streams.
Dividends are paid out of spare cash that a company does not want to put to other uses, such as building factories or hiring new staff. So I look for companies that already have proven business models and look set to keep being highly cash generative.
One dividend share to consider
As an example, one share I think investors should consider is FTSE 100 asset manager M&G (LSE: MNG).
The company’s business model is pretty simple and, thanks to the large sums involved, even modest fees and commissions can soon add up.
M&G has a customer base in the millions across multiple markets. I reckon its strong brand is an asset when it comes to attracting and retaining clients.
I also like the fact that its dividend policy is to maintain or raise its dividend per share each year. Dividends are never guaranteed at any company. So whether M&G is able to keep delivering on that aspiration (as it has done so far) will depend on its future business performance.
One concern I have in that regard is M&G’s recent struggles to tempt investors to bring in more new funds than they withdraw. If it cannot reverse that trends, it could mean smaller free cash flows in future.
Aiming for a target income
Something I like about M&G, though, is its high dividend yield of 7.8%. That means that £1,000 invested in M&G shares today will hopefully earn £78 of passive income annually.
How much needs to be invested to hit a target annual income depends on yield. For example, at a more modest 5% annual yield, a £10,000 annual passive income would require a £200,000 portfolio. That 5% is still well above the FTSE 100 average.
At different yields, a higher or lower amount would be needed. But as dividends are never guaranteed, I do not just chase yield. I always look at how a company earns its money and consider how sustainable its free cash flows look.
What if someone wanted to target a £10,000 passive income but does not have £200,000 to spare? They could build up to it, even from zero today, by drip feeding some money regularly into their ISA or share-dealing account.
