Passive income is exactly what it sounds like. Money that comes in – without having work for it.
That might sound too good to be true. But examples of passive income abound, from inheritance trusts to people who rent out their empty parking places.
Here is my plan to earn passive income by putting aside just £100 a month.
Shares as passive income ideas
With £100 a month, I’d start saving regularly in a Stocks and Shares ISA. £100 a month might not sound that much. But it adds up to a four figure sum each year. That’s enough for me to start generating passive income streams.
Just putting money away wouldn’t earn me passive income, though. That’s why I’d start to invest in shares. To maximise my passive income streams, I would look for high yielding shares. These are stocks where the dividend is large relative to the share price.
Passive income example
For example, today I could buy a share of British American Tobacco for around £28.32. This year its dividend payout is 215.6p. That equates to a dividend yield of 7.6%.
In other words, if I put £100 into BAT shares this month, I would expect to receive £7.60 over the coming year. I’d also receive any dividends declared in future after that. I’d still own the shares. I could sell them in future if I wanted, though might not recoup my purchase price.
Risks
But things might not work out that way. For example, BAT has paid out a growing dividend since the turn of the millennium – but that is no guarantee of future dividends. Dividends are funded by cash flows. While BAT’s brands such as Lucky Strike allow it to generate meaty cash flows, smoking is declining in many markets. BAT also has a lot of debt it needs to service, eating into free cash flows.
To help lower risk in my passive income plan, I’d diversify. That involves spreading my risk by investing in different shares, across a range of sectors.
Identifying high yield shares
How can I discover high yield shares?
A lot of information sources publish historical share yields. But to generate passive income my interest is in what a share’s future dividends might be. Past dividends are not a reliable guide to future ones.
Take GlaxoSmithKline, for example. The pharma company currently yields 5.8%. For a blue chip name that is attractive. But a little research reveals that GSK has already indicated a likely reduction in its overall dividend level when it splits into two companies soon.
I try to avoid what might be a ‘value trap’. A value trap can be dangerous for unwary investors. Historical data can make it look attractive, but future prospects can be sharply different. That is why I always research my income picks, to try and identify any signs of a possible value trap. I focus on future passive income prospects, not purely historical data.
Compound effect and passive income
Over time, if I keep putting £100 each month into new passive income ideas, I will add more shares to my portfolio. But I would also hope for regular dividends.
Instead of spending this income, I could combine it with my monthly £100 when buying more shares. That compound effect should help my portfolio grow over time – and the passive income will hopefully also increase.