Passive income is supposed to be about earning money without needing to work for it. But a lot of schemes some people use for that objective do not seem very passive to me.
My own approach involves piggybacking on the hard work of proven businesses.
By buying shares in FTSE 100 companies that pay dividends, I aim to build my own income streams without increasing my workload.
That approach does not necessarily need money upfront or even large cash outlays along the way. If I had a spare £8 a week, here is how I could use it to try and grow my income.
Get ready to invest
First, I would set up a share-dealing account or Stocks and Shares ISA. I would put my £8 per week into that.
Once I had saved up enough money and chosen the shares I wanted, I would be ready to invest. £8 a week might not sound much, but it adds up to over £400 per year.
Understanding dividend shares
But the cash alone is not the point of my plan. Rather, I would use it to buy shares I hoped could pay me passive income in the form of dividends.
Dividends are basically how a company shares some or all of its profits with shareholders. Dividends are never guaranteed and past performance is not necessarily a guide to what will happen in future. So I look at how much I think a business might pay in dividends down the line.
To do that, I stick to businesses I understand and that I think I can assess. I look for ones that have some competitive advantage in a market I expect to remain large. Then, by reading the firm’s financial statements, I try to understand how much free cash flow it might be able to generate.
Whereas profits are an accounting concept, free cash flow is the amount of hard cash coming in or going out of a business. That matters because paying dividends takes cash. As well as the operational side of a business, I look at its balance sheet. Servicing debt can eat into cash flows.
Setting up income streams
Even if a company seems like it has good dividend prospects to me, I diversify my risk by spreading my investments.
Imagine I achieve an average dividend yield of 7% on my portfolio (which is less than the current yield on FTSE 100 shares I own including British American Tobacco, M&G, and Vodafone).
That should generate £29 in annual dividends – not a bad start but not the stuff of passive income dreams! The key, I think, would be for me to keep going and initially to reinvest my dividends rather than taking them out as income.
Doing that, after five years I should already be earning £167 in passive income each year.
That example presumes flat share prices and dividends and in reality they could move up or down. But it makes the point that modest regular savings, buying well-chosen shares, and dividend reinvestment could help me build growing passive income streams from a standing start.
