Buying shares that pay dividends is a simple but sometimes highly effective way to generate passive income.
Doing that I could make the plan work for my own financial circumstances. By choosing how much to invest and then finding the right sorts of shares to buy, hopefully I could earn money without having to work for it.
As an example, imagine I wanted to earn an average £300 each month in passive income. Here is how I would set about trying to achieve that goal.
Saving according to my means
I would set up a share-dealing account, or Stocks and Shares ISA, then try to pay into it on a regular basis.
One approach would be simply to make ad hoc contributions when I had spare cash. But take December as an example. There is often less spare cash lying around at this time of year!
By setting a regular saving target, hopefully I could inject some discipline into my fund building while still sticking to an approach that worked for my own financial circumstances.
Finding shares to buy
My next move would be identifying the sorts of shares that may have the potential to meet my investment objectives.
Not all shares pay dividends. If a business does not generate enough free cash flow, it may cut or eliminate the shareholder payout.
So I would be looking for businesses I felt had some strong competitive advantage in a large, durable market. That could help them generate cash that could be used to pay a dividend – and earn me passive income!
Portfolio and pricing
But even the most promising business can disappoint, so I would spread my portfolio across a diverse range of shares.
I like the juicy dividends of British American Tobacco, for example. But cigarettes are losing popularity and that could hurt the firm’s cash flow generation potential. So the Lucky Strike maker is only one of the income shares I hold in my portfolio.
I would also focus on paying no more than I thought a share was worth, allowing for a margin of safety. If I overpay for shares I could end up losing more in capital than I earn in dividends. That is the opposite of what I want to achieve!
Keeping the target in sight
How much I earn will depend on the amount I have invested and what my average dividend yield is. That is the annual dividend I earn from a share expressed as a percentage of its purchase price.
I could try and speed things up by reinvesting my dividends at first (something known as compounding) rather than using them as passive income.
For example, if I invested £100 a week at an average yield of 7%, I could hopefully generate income streams of £300 a month in under eight years. At that point (or indeed any point along the way) I could stop compounding the dividends and instead take them out as passive income.
