One of my favourite passive income ideas is owning dividend shares. When a large company like Unilever or Lloyds Bank pays a dividend, if I own its shares then I will receive money. By buying a range of such shares, I can target a certain level of income.
Here, for example, is how I could aim to earn £50 a week using this approach.
Buying great businesses, not big dividends
I would take time to research the sorts of dividend shares I could buy. Just because a share has paid a dividend in the past does not mean that it will do so again in future. Instead of focussing only on the history of shareholder payments, I look at the fundamentals of the business. For example, how big is its market? What competitive advantage does it have that will help it appeal to customers in the future? How profitable is its business model?
If I can find what seems like a great business in terms of its ability to generate profits, it might be a good investment for my portfolio of dividend shares.
Spreading investments
However, sometimes a business looks strong but some unexpected turn of events changes its situation. So instead of putting all my eggs in one basket. I make sure to diversify across a number of different shares.
I also try to avoid too much concentration in a single area of the economy. For example, tobacco shares like British American Tobacco and Imperial Brands currently pay chunky dividends. But at the moment, those rely on the large cash flows generated by selling cigarettes. With a decline in cigarette sales in most markets, there is a risk that free cash flows could fall at many tobacco-focussed companies. So although I own both of these British shares in my portfolio, tobacco is only one of a number of business sectors in which I have invested.
Setting a target
To try and earn a certain amount per week – such as £50 – I would invest. But how much I need to put into shares will depend on what is known as their dividend yield. That is basically the dividend expressed as a percentage of my purchase price for the shares.
For example, National Grid has a dividend yield of 4.9%. That means that if I spend £100 on National Grid shares today, hopefully I would earn £4.90 in annual dividends. At that sort of yield, to target £50 a week in dividends, I would need to invest around £53,000.
Finding dividend shares to buy
If the average yield of my portfolio was higher than National Grid’s 4.9%, I might be able to earn £50 a week by spending less than £53,000 on shares. But remember – I am focussed on finding great businesses in which I can invest. Simply chasing high yields alone does not match that style of investment. I would hunt for quality businesses first and only later consider their yield.
Once I found a range of dividend shares I felt matched my style, I could calculate how much I need to invest to try and hit my target income. If that was more money than I could comfortably invest at the moment, I would still follow the same approach but simply lower my initial income target.