Passive income may seem like a pipe dream but it’s not as hard as it sounds to set up. One way to get passive income is to invest in shares that pay out dividends. By putting money into shares, you own a piece of a business and are then entitled to a piece of the profits in the form of dividends.
An attractive element of dividend investing is that you can go on receiving dividends for as long as you own the shares. So putting money into a dividend-paying share today could lead to passive income for decades, even without any further investment. However, that might not happen – as was seen last year, even big companies can cut or suspend dividends.
High-yield UK shares
Yield is a key question when selecting UK shares for passive income. Yield is a function of the dividend as a percentage of the cost price. Say, for example, a share pays out a dividend of 10p a year. If the shares trade at £10, the annual yield will only be 1%. But if the shares trade at £1, the annual yield will be 10%. That makes a big difference to passive income, which is why people often look at a share’s yield.
Historic dividends aren’t necessarily a guide to future payout levels. So when looking at yield, as well as the current share price, I also look at how sustainable a company’s dividend looks. For example, how much free cash flow does it generate and does that enable it to cover the dividend?
Here are three well-known UK shares I’d pick for passive income.
GlaxoSmithKline is a well-known pharmaceutical and consumer healthcare company with brands such as Aquafresh, Panadol, and Nicotinell in its portfolio. It has held its dividend steady for a number of years, rather than raising it. That sometimes raises questions about whether the business can continue to grow its earnings, and GSK’s pipeline of new drugs does underwhelm some analysts. I think that is one reason its share price has underwhelmed over the past year.
I think that has opened up an opportunity for investors, however. With the blue-chip stock currently yielding almost 6%, I would pick it for passive income.
Diversifying my passive income
A passive income share in my portfolio already is Imperial Brands. The British tobacco group owns brands including Lambert & Butler and Gauloises. The company recently unveiled a new strategy focusing on its core cigarette business in leading markets such as the UK and US. That hasn’t helped the share price, so currently the shares are yielding over 9%.
That is very tempting to me. Tobacco use is declining in many markets, which could hurt Imperial. But I think the company can partly offset that by raising prices. I think it has a long future ahead of it.
Investment manager M&G would be my third passive income pick among UK shares. I think it’s important to diversify one’s portfolio to help reduce risk. Opting for the financial services sector instead of choosing another consumer goods or tobacco name would help me diversify.
M&G is yielding over 6%. Its business in investment management and pensions is mundane but predictable. That gives me more confidence it can prosper in the future. However, it is a hotly competitive market with new entrants, including fintech firms, which could impact future returns.