Dividends are an important factor for long-term investing and they’re key to earning a passive income from UK shares. Let’s consider the FTSE 100 index. Over the past 25 years, the FTSE 100 returned 6% per year including dividends. But, without dividends, it returned just 2.3% per year. Quite the difference.
I hold many growth stocks in my Stocks and Shares ISA, but I also like to diversify by owning dividend paying shares for a passive income.
My favourite passive income shares
To generate a passive income, I look for shares that provide a dividend yield of at least 5%. In addition, its even better if they have been consistent dividend payers over many years. Of course, dividends are not guaranteed and can be cut at any time.
Stocks that fit these criteria include the global commodity giants Rio Tinto and BHP Billiton. I like that Rio Tinto provides a forecast rolling dividend yield of over 9% and BHP distributes almost 8%. It’s also good to see that both have consistently provided dividends to investors over the past 10 years.
It could be a decent time to look at these mining giants given their cyclical nature. Several major countries including the US are significantly increasing infrastructure spending, and demand for commodities could be robust.
In addition to providing high dividends, they both display good quality metrics. In particular, they offer a double-digit return on capital and strong operating margins.
A word of warning, however. Iron ore prices are approaching multi-year highs and any decline over the coming years could impact profitability and dividend yields for Rio and BHP.
Building passive income
My favourite UK housebuilder stock, Persimmon (LSE:PSN), provides an excellent passive income. It offers a forecast rolling dividend yield of almost 7.5%. It’s also pleasing to see that it has a consistent dividend record over the past five years.
Much like Rio and BHP, Persimmon offers investors a high-quality share with a double-digit return on capital. It also offers a decent 24% operating margin, and an undemanding price-to-earnings ratio of 13 times.
Its end markets are supported by record low interest rates, and ample lending availability. In addition, government incentives with stamp duty discounts are helping to support the housing market.
I believe Persimmon is an all-round quality share providing substantial passive income to investors. That said, any reversal of stamp duty incentives could limit house buying activity. With a cyclical recovery in progress, if inflation rises too far and too fast, interest rates are at risk of rising over the coming years.
All things considered, Persimmon has proved itself to be an industry leading business, and I’m happy to continue holding onto my shares.
Small company, large dividends
Passive income from UK shares isn’t just restricted to large FTSE 100 companies. Smaller companies can often provide greater potential for share price appreciation. One small company that I think could provide investors with growth and dividends is Somero Enterprises. It offers a near 10% dividend yield, solid balance sheet, and excellent returns.
As a manufacturer of specialist equipment for concrete flooring, it could benefit from a cyclical recovery too. Bear in mind though, it is a cyclical industrial company, and any economic downturn could negatively affect its shares.
Overall, its above-average dividend yield provides a safety cushion and I’d be happy to own the shares.
Harshil Patel owns shares in Persimmon. The Motley Fool UK has recommended Somero Enterprises, Inc. 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.