There are multiple ways to earn passive income but my favourite method is owning dividend shares.
Dividends are paid to shareholders in return for investment in a company. They’re effectively a share of the profits.
But with hundreds of FTSE stocks available to buy, how can I sift through and find the best options for an income top-up.
Crunching the numbers
First, I’d start with a target. Let’s say I want to earn £100 every month in passive income. That’s £1,200 a year. To achieve this goal, I need to calculate how much I’d need to invest.
The answer depends on the dividend yield of the shares that I buy. Right now, the average FTSE 100 yield is just over 4%. According to my calculations, that means I’d need to invest £30,000 to reach my goal.
But I reckon I could earn £100 in monthly dividends by investing just half of this sum. I’d aim to do this by finding shares that yield over 8%.
Looking the FTSE All-share index, I note that 41 shares offer dividend yields of 8% or more. But I’d want to narrow down my list to five top stocks.
My criteria
A company’s dividend yield isn’t the only factor to look at. A high yield is no use to me if it’s not sustainable, or reliable.
I want my dividends to be affordable for the company to continue paying out. That’s why I prefer dividend cover of greater than 1.2 times.
Dividend cover measures how much a dividend is covered by a firm’s current earnings. A figure of less than one indicates that it doesn’t earn enough to cover its anticipated payout.
Granted, it could still pay from its cash reserves, but I prefer companies that don’t need to dig into their savings.
For reliable passive income, I’d want to pick stocks that also have a consistent and long dividend history. And looking to the future, I’d want confidence that earnings will be sustainable.
Top passive income stocks
So which stocks meet my criteria? If I had some spare cash right now, I’d buy Rio Tinto, Taylor Wimpey, Phoenix Group, Legal & General, and Imperial Brands.
This group offers a 9% dividend yield. In addition, it has average dividend cover of 1.8, which implies that earnings comfortably exceed dividends.
Lastly, this selection has an average 18-year history of consistently paying out cash to shareholders.
Bear in mind that global miner Rio Tinto and UK housebuilder Taylor Wimpey are both cyclical businesses. Earnings could fall in a recession. That could result in a dividend cut, reducing my dividend income.
However, my selection diversifies by owning shares across several sectors. Instead of putting all my eggs in one basket, I’d be spreading my risk across each share equally.
Also, share prices can swing up and down. But as I’d own quality companies that I expect to thrive over many years, I can effectively ignore day-to-day share price volatility. Instead, I would hope to enjoy a steady stream of passive income.