Putting money into dividend shares is one way to try and earn a passive income. The thinking goes that, thanks to companies paying dividends to their shareholders, investors could potentially earn money without having to work for it. Is that true?
With FTSE 100 companies alone paying out well over £1bn a week on average in dividends, a lot of people do indeed earn sizeable passive income streams using the approach.
Setting a target
How much passive income might be generated depends on a few key factors. In the short term it is a function of how much is invested and at what dividend yield.
Yield is what you ought to earn as an investor, expressed as a percentage of what you invest. So for example, a 5% yield means earning £5 a year on each £100 invested.
£1,300 a month adds up to £15,600 a year. At a 10% yield, that would require an investment of £156k. But a 10% yield is unusually high (the FTSE 100 average is currently 3.3%). With a 5% yield, for example, hitting that target would require £312k.
A couple of snags – and a possible solution
You may immediately see a couple of possible problems with that. First, few people have a spare £356k lying around. Even if they did, the standard annual contribution allowance for an ISA is £20k.
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So an alternative approach is to build the amount over time. Investing £20k a year and compounding at 5% annually, it would take 12 years for the portfolio to grow large enough that a 5% dividend yield would generate £1,300 in passive income each month.
If the yield was higher, that timeline would be shortened. In the current market I do think a 6% or 7% yield while sticking to blue-chip shares is possible. However, to err on the side of caution, in my example I use the more modest 5% figure.
Finding shares to buy
As no dividend is ever guaranteed, it is important to diversify across different investments. One dividend share I think passive income investors should consider is Mondi (LSE: MNDI).
Given that the share price has tumbled 44% in five years, while the FTSE 100 index of which it is part has gone up 60% in that period, I ought to explain why I think it is worth considering!
As a packaging group, Mondi has been hurt by higher costs and weaker demand damaging profitability in the industry in general versus a few years ago.
But Mondi remains solidly profitable. Its first half showed year-on-year revenue growth. The company has a large global footprint in an industry where the high cost of setting up factories and supply chains can act as a barrier to entry for rivals.
From a passive income perspective, the 5.8% yield looks attractive to me. After that five-year share price fall, I see the current price as attractive.
Getting started
Of course, choosing the right shares is an important part of any passive income plan based on earning dividends. But fees and costs like commissions can eat into earnings. So it is also worth taking time to evaluate carefully the different options when it comes to choosing a Stocks and Shares ISA.
