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Earning passive income through shares

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Passive income may seem like a fairly modern phrase. The truth is that investors have been making passive income for years. 

Passive income in shares through dividends

Passive income in the stock market comes by way of dividends. Dividends, for those who don’t know, are a distribution of a company’s profits to its shareholders. It is easy to forget, but when you invest in a company you become a (very small) partial owner of that company.

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Shares usually come with voting rights, and large corporate deals often involve some purchase or sale of shares. As a partial owner, investors get to shares in the profits without actually having to work for the firm (or much at all). This is passive income at its purest.

Not all companies pay dividends of course, and those that do pay different amounts. It is also a precautionary tale that, just as with a business you run, there can be good times and bad. When times are good you will earn more profit (that is dividends), but when times are bad you will earn less or even none.

Dividend yield is key

One of the greatest benefits of earning passive income through shares is that dividends are not actually paid as a percentage. In the UK firms pay dividends on a pence-per-share basis. Naturally the high the payout the better, but as a percentage return on your investment, it is highly dependent on the share price.

This can be great news, because even if a firm has not changed its dividend payout, when its share price is low you can “lock in” a high dividend yield. The dividend yield is simply the percentage annual return on your investment – in simple terms calculated as dividend per year/share price.

Of course, judging the share price is a little more difficult. Though it may be easy to see when a low price is driving a high dividend yield, it is harder to know if this is a short blip in the stock or a fundamental shift.

Many such blips happen all the time, when some short-term news story drives selling for example. In these cases, the fundamental strengths of a firm don’t change, just immediate public opinion. Fear and greed are usually the main drivers of share prices in the short run.

Sometimes, however, the problems bringing the price lower will be more fundamental. If weaknesses in a company are driving the price lower, it will not be offering good dividends for long.

Despite this, though, some basic guidelines can help. Always look at larger, blue chip forms, for example, which usually run less risk of a massive share price crash. Diversify across a number of dividend shares to lessen the risk of any one company on your portfolio.

As I said, passive income is by no means new. With good guidance and some common sense, investing in shares could be the way forward for many people.

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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