Passive income is the stuff of dreams – money that comes in without needing to labour for it. But it is also the stuff of reality. Millions of people have passive income streams in the form of dividends from shares they own.
Here is my own five-step passive income plan built around buying dividend shares.
1. Get money to invest
First things first. How can I buy dividend shares if I do not have money to invest?
The answer is: I can’t. If I have some cash to start with, I can use that to invest. But if not, it is still possible for me to save some money on a regular basis and use that as the foundation of my passive income plan.
In fact, that is one of the things I like about dividend shares as passive income streams compared to some other ideas such as buying a rental property. I do not need a large sum of money in the first place to get going.
My approach would be to set myself a regular, consistent target of how much I want to put aside. I would try to balance making this achievable with setting the amount at a high enough level that I soon start to see my investment pot grow to a size where I can start investing.
2. Learn about the stock market
A lot of people think that a good company makes for a rewarding investment. But the reality is more complex. That is because valuation also comes into play. If a company’s shares trade at a high price, I may not make money investing in it even if the business does very well.
That is why I would want to learn about the stock market and the role dividends play in my passive income plan. Specifically, I would want to get more knowledge about how and why dividends are paid, or not.
For example, what is the relationship between a company’s free cash flow and its ability to pay dividends? If a company makes big profits but also carries a lot of debt, could that impact its dividends? What is the importance of dividend yield in helping me calculate my passive income targets?
Such topics matter a lot because future dividends at any company are an unknown quantity. Even firms that have paid dividends for decades can suddenly stop. General Mills has paid an annual dividend since the 19th century – but that is not an indication that it will keep doing so.
By learning about how companies fund their dividends, I can make my own judgments about how likely I think they are to pay them in future. That matters because dividends are at the heart of my passive income plan.
3. Draw up a list of dividend shares to buy
Once I feel comfortable with how companies pay dividends, I would start my search for shares I could use to build my portfolio.
With hundreds of shares listed on the stock exchange, how would I decide where to start? Like billionaire investor Warren Buffett, I would stick firmly to my circle of competence – in other words, industries I feel I understand. Whether that is electric vehicles or supermarkets, industrial gases or the rag trade does not matter.
The key point is that if I understand an industry, I am more likely to be able to assess the prospects of companies that operate in it. So I would stick to what I know at any given time. I can always learn more about an industry if it interests me but I do not understand it.
So what am I looking for when choosing dividend shares for my portfolio? First, I want a company that already has a proven ability to generate profits, not just a firm I think could do so in future. Secondly, I want a company with a business model I think could help it keep making big profits in future. That relies on there being a sizeable customer market to address in future.
But I also look for the company to have some sort of competitive advantage in that market, like the unique brands owned by Guinness brewer Diageo, or the unrivalled distribution network of National Grid.
I also look for a company that seems committed to paying dividends, even though they are never guaranteed. For example, in the pandemic when many rivals suspended their payouts, Legal & General kept paying its dividend.
4. Choose what to buy
From this list I would select companies to buy. I would look to invest in a range of industries, to reduce my risk profile if one company or business sector hit hard times.
At this point, I would also consider share price and what it meant for the dividend yield I could get. To earn £500 a month in passive income — £6,000 annually – I would need to invest £60,000 if I bought shares with an average yield of 10%. But if I bought shares with an average yield of 2%, I would need the much bigger amount of £300,000.
I would not buy shares just because they had a high yield. But if a company I thought had a great business offered me a fairly low yield – like engineer Spirax-Sarco – I would not buy it as part of my passive income plan.
5. Buy shares and earn passive income
Once I had enough money to invest I would use a share-dealing account, or Stocks and Shares ISA, to start buying shares. Hopefully, the portfolio would start to generate dividends income for me. Once I owned shares I would get any dividends they paid out while I held them so over time, if I kept saving, I would hopefully see my passive income streams grow.
If I did not have a lump sum to invest and set aside a certain amount regularly, I would not expect to get £500 in monthly income in the beginning. But I could build up to that target over time, adding to my investment fund and hopefully benefitting from choosing shares with compelling investment cases and passive income prospects.