The idea of earning passive income year after year appeals to a lot of people, including me. One practical way I aim to put that idea into action is by buying dividend shares.
At the moment, a lot of blue-chip British businesses have cheap valuations in my view. That means that I can pile up quite substantial dividend streams relative to what I invest.
If I had a spare £10,000 to invest today, I think I could generate a four-figure passive income from it in coming years. Here’s how.
Targeting a 10% yield
To earn £1,000 per year by spending £10,000 on dividend shares, I would need to earn a dividend yield of 10%.
Various London-listed shares currently offer such a yield, from the 11.4% of Income & Growth Venture Capital Trust to the 16.1% on offer at Diversified Energy.
But all shares carry risks.
So I would spread my portfolio across a range of companies. With £10,000, I could invest a couple of thousand pounds in each of five different companies. That would help cushion the blow if a dividend share I own cuts its payout.
I would also stick to blue-chip shares with business models I thought had strong future potential. Among the FTSE 100, shares currently yielding 10% or more include names like M&G and Vodafone.
Focus on quality
Not all of those shares are equally attractive to me, however.
M&G faces risks, such as choppy markets leading to investors withdrawing funds, hurting profits. But it raised its dividend 7% this year and I am upbeat about the outlook for the business.
Vodafone has past form in cutting its dividend, which has not been increased for years. With a large debt pile, cutting the dividend could appeal to management. The telecom operator’s 10.7% payout could be a great income source for investors if it remains. But I see a risk of a cut.
So, when choosing dividend shares for my portfolio, I do not just look at their yield. My main focus is on finding great businesses to buy into when they have an attractive share price. Only then do I consider yield.
Long-term investing
That does not mean I could not hit my goal. Some businesses I own (like M&G) and others I would happily own if I had spare funds to invest (such as Income & Growth) already have a double-digit yield.
But as a long-term investor, I could still aim for my target even by buying shares that yield less than 10% today.
I would do that by compounding, which basically means reinvesting the money I receive from my dividend shares.
If I invest in shares yielding 8% annually and compound, after three years my dividend shares should already be throwing off more than £1,000 each year that I could take in cash if I wanted.
Over time, if I have bought into good companies, hopefully the dividends would grow. Putting £10,000 into dividend shares in today’s market could be a very lucrative move for me over the long term.
