There are different ways to earn passive income and one that I like myself is investing in blue-chip shares that pay dividends. Doing that with a £20,000 ISA could see income streams of hundreds of pounds per month in future. Here’s how.
Dividend income from proven businesses
Dividends are one way for a business to use excess cash it generates. There are others, though – and not all businesses generate spare cash. So, dividends are never guaranteed and even when they have been paid before, they are not guaranteed to last.
Therefore, I think it is important for an investor to take care when choosing dividend shares for their ISA. For example, just looking at a current yield does not necessarily set a reasonable expectation of likely future income. Instead, one needs to understand the source of a firm’s free cash flows and how likely they are to continue.
For example, does it have a proven business model? As it grows sales, does it make money or lose money? What sorts of expenditure might crop up, using up money otherwise available to pay dividends?
Big companies can pay big dividends
But while dividends can come and go, a diversified selection of the right shares can generate meaningful passive income – especially for someone who is willing to take a long-term approach to investing.
For example, if a £20,000 Stocks and Shares ISA was compounded at 8% annually for 15 years, it should grow to a size where an 8% dividend yield would equate to £423 per month on average in passive income. That is without having to take any capital out of the tax-free wrapper.
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That 8% is well above the current average FTSE 100 yield of 3.3%. But the compound annual gain I mentioned above can be driven not only by dividends, but also by share price changes. And while the average yield is 3.3%, plenty of FTSE 100 firms offer higher yields.
A high-yield performer
As an example, one share I think investors should consider is Lucky Strike manufacturer British American Tobacco (LSE: BATS).
Not only it its yield 6.3%, the company aims to keep raising its dividend per share annually – as it has already done for decades.
Can it do that?
On the one hand, a strong stable of premium brands and proven massive cash flow generation potential work in its favour. On the other hand, declining cigarette sales volumes pose a challenge to the business even maintaining, let alone growing, its profitability. Revenues have fallen for the past couple of years in a row.
All shares involve risks, but the long-term demand picture for cigarettes is a notable risk, in my view, not only for British American but also rivals. However, I continue to think it has sizeable cash generation potential as a business. It continues to sell billions of cigarettes per week.
Getting started
In my example I mentioned a £20,000 ISA. The same approach could work with less money – even much less – although the passive income streams generated would be proportionately smaller.
An obvious first move for a passive income hunter would be to compare some of the many different Stocks and Shares ISAs available, to decide what one suits their own needs best.
