Different people earn extra income in a variety of ways. One common approach is to buy shares in companies that pay dividends.
But is that a realistic way to make a meaningful passive income stream in real life?
What drives income
Imagine I had £20,000 and put it in a Stocks and Shares ISA. I then use that to buy dividend shares. How much I could earn will depend on two things.
One is how much I invest. The second is the average dividend yield I earn. Yield basically means the annual extra income I would earn from dividends, as a percentage of the money I invest.
Digging deeper
But neither of those things is quite as straightforward as they may sound at first.
How much am I investing, for example? Putting £20,000 in makes it sound like that is all I am investing. It could be. But I also have the choice of reinvesting the dividends I earn in future, something known as compounding. That would mean I could invest more than £20,000 over time, without having to stump up more than my initial £20,000.
As for yield, that is not fixed. Dividends are never guaranteed. They can go up, but they can also go down, or be cancelled altogether.
By spreading my £20,000 over a range of different shares, I would limit the impact on my likely earnings if any one of them did poorly.
Still, a high yield when I buy does not always mean that I will earn that much down the line. If I had bought Persimmon last year when its percentage yield was in the mid teens, I would now be earning markedly less from it than I had expected after it cut its payout.
Focus on quality and valuation
That explains why I do not buy shares just because of their yield. Instead, I aim to buy shares in great businesses trading at an attractive valuation.
With generating extra income as my goal, I would also focus on companies I thought could generate substantial free cash flow to fund future dividends. So that would rule out businesses like Amazon and Alphabet, which currently reinvest profits inside their business rather than divvying them up among shareholders.
Setting expectations
I own some shares with percentage yields in the high single digits, like M&G and Altria. But a lot of dividend shares have a lower yield.
If I could hit an average of 7%, my £20,000 ISA could earn me an annual £1,400 in extra income. Simply by compounding dividends for a decade rather than taking them out of my ISA, I could then start to draw a higher annual income of £1,628.
That is not allowing for dividend increases in the meantime. Although dividends could fall or rise, hopefully if I invested in the right businesses at an attractive price, I may well benefit from growing dividends. My M&G shares, for example, paid me a 6% higher dividend per share this year than last year.
