As once daily expenses like coffee treats and travel restart, I see now as a good time to think about passive income investments. Rather than just getting back into old spending habits, I’m focussing on setting up new passive income streams.
Here I explain why I use dividend shares for passive income investment. I also explain how I would consider investing £250 each month.
Dividend shares as passive income investments
Not all shares pay out dividends. That doesn’t mean they aren’t attractive. For example, a growth company may reinvest profits to grow faster. That could help its share price appreciate.
But for passive income, I prefer to look for shares that pay out dividends. What’s that? A dividend is basically excess money a company pays out to its shareholders.
Not all companies pay dividends, so I start by looking at a company’s dividend policy. Normally this is easy to find – it should be on its most recent annual report online. A dividend policy is just a statement of intent, however. Even if a company aims to pay dividends, events can intervene. For example, during last year’s challenging market, dividend payers like JD Wetherspoon, Greggs, and HSBC suspended their shareholder payouts. That is always a risk with dividend paying shares.
Free cash flow
Next I look at a company’s cash flows. Essentially this details money coming in such as revenue and investment gains, set against outgoings such as staff costs and rental payments. The greater a company’s free cash flow, the easier it will find it to pay dividends.
A company doesn’t have to be free cash flow positive in a given year to pay dividends. But over time, if a company keeps bleeding money it typically would struggle to pay dividends.
Why do I zoom in on free cash flow and not earnings, a figure which is sometimes easier to find? A company’s earnings are a useful indicator of its financial performance. But not all the items they include involve cash. For example, amortisation may reduce earnings. But an amortisation expense does not necessarily represent cash going out the door.
Cash is what a company needs to sustain dividends over the course of years. So I find free cash flow the most useful metric when considering the potential of passive income investments.
Drip feeding in passive income investments
I find £250 a month is enough to start setting up a passive income stream. At £3,000 a year, it would allow me to diversify across different companies and sectors. That is an important way to manage my risk, in case one company’s performance turns sour.
At first I would stick with a couple of blue chip names with attractive dividend payouts. Dividends are never guaranteed, though.
With adjusted free cash flows of £7.3bn before dividends last year, British American Tobacco was able to raise its payout once more. Yielding 7.5%, each £250 I put into the company would prospectively offer roughly £18.75 of passive income each year. However, declining cigarette volumes in many markets are a risk to future revenues and profits.
I’d also consider putting money into financial services provider M&G. Its dividend yield is even higher than BAT’s, at 7.7%. So with £250, I would be hoping for an annual payout of around £19.25. But risks include any economic contraction damaging demand for the company’s financial services products.
