Like many people, the idea of earning money without working for it appeals to me. But rather than simply having that as a dream, I have tried to take a practical approach to setting up passive income streams.
Specifically, I have purchased shares in a variety of blue-chip companies that pay me regular dividends. Doing that helps me to benefit from the success of proven, profitable businesses.
By owning shares in different companies, I can hopefully still earn passive income even if one of them stops paying dividends.
This approach also lets me invest at a rate suitable for my own financial circumstances. If I wanted to aim for £200 per week on average in dividends by putting aside £5 per day, here is how I would go about it.
Taking the long-term view
A fiver a day is not realistically going to earn me £200 per week in passive income any time soon.
I may be able to hit that target, but it will take years or decades. My approach to dividend shares is that of the long-term investor. By investing regularly now, I hope to reap the rewards in years to come.
Finding dividend shares to buy
Not all shares pay dividends. Some that do today may suddenly stop. It happened to Direct Line this year, despite what previously looked like a very juicy payout.
So rather than focusing on a company’s current dividend, my starting point is always to look at the future cash generation potential of a business.
If a business has a large potential market of customers, it may be able to make a lot of sales. But competition could mean those sales are not profitable. So I look for a company with some sort of unique competitive advantage that helps it set prices at a profitable level.
That could be brands like those owned by Unilever, or a unique network that is impossible to replicate, like that of National Grid.
However, profits are an accounting concept. A company can be profitable on paper while still seeing money go out the door, for example because of a series of one-off expenses it can adjust for in its accounts.
That is why I also always look at what I think a company’s free cash flows are likely to be in future. After all, that is what funds dividends.
Aiming for a target
The average dividend yield of my portfolio helps me estimate how much passive income I might earn from it. For example, every £100 I have invested in shares yielding 7% will hopefully earn me £7 a year in dividends.
My target of £200 a week on average amounts to £10,400 annually in dividends. If I averaged a 7% dividend yield – something I think is realistic in today’s market even sticking to FTSE 100 shares – that would require me to have a portfolio of around £149,000.
Building up to that would take 81 years! However, if I reinvested dividends as I went (something known as compounding) then hopefully I could hit my target after 28 years.
