The idea of earning regular passive income is an attractive one. I try to do just that by investing in dividend shares.
For now, at least, that does not give me enough passive income to substitute for a full-time wage. But it can be a handy supplement. If I wanted to target £100 each month in income from dividend shares, here is how I would go about it.
Dividend yield
The amount of earnings I can expect from dividend shares basically depends on how much I invest and the average yield I earn. The concept of dividend yield is therefore important to understand in this context.
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As an example, the yield on AstraZeneca shares is currently 2.3%. So if I invested £1,000 in the shares today, I would hopefully earn £23 in dividends from them next year. Telecom group Vodafone has a much higher yield of 7.4%. So £1,000 invested today would hopefully earn £74 in dividends next year.
Risks and rewards
However, that yield is based on the dividends those firms have paid in the past year. That is no guarantee of what will happen in the future.
After all, Vodafone had net debt of €41.6bn at the end of its last financial year. It may decide that it wants to use cash flow to pay down debt faster as interest rates rise, rather than paying dividends. Until last year, AstraZeneca had held its dividend flat for a number of years. It is now growing, but that could go into reverse if, for example, the company fails to come up with new blockbuster drugs to keep profits buoyant. Conversely, a big and profitable new discovery could lead to the dividend rising sharply.
So when looking at yield, I also try to consider what might happen in future that could change a company’s ability or willingness to pay dividends. For example, will it continue to generate free cash flow at the same level as today, or higher? Will it have competing demands on its cash that might curtail dividends, such as high capital expenditure requirements or debt repayments? Even a very profitable company can decide not to pay dividends – Google parent Alphabet is an example.
Aiming for my target
Based on the average yield of the shares I buy, I can estimate how much I need to invest to try and hit my target. To reduce risk I always diversify across a range of shares, which is why I would look at the average yield, not the yield of a single share. More specifically, I would use a weighted average if I invested different amounts in the dividend shares concerned.
Aiming for a monthly income of £100 would mean I want to generate £1,200 in dividends annually. At an average yield of 5%, that would require me to invest £24,000. If the average yield was 10%, I would only need to invest £12,000.
Choosing dividend shares to buy
But unusually high yields can be value traps, for example because a company’s future earnings are likely to be less than they were before.
So I would focus first on finding businesses I felt had compelling long-term prospects and sold at an attractive price. Once I had found such businesses, I could then consider their dividend yield.
