Using money to make money is an old idea – and one that is still very relevant today. The passive income potential of owning dividend shares is massive. FTSE 100 firms alone pay out well over £1bn of dividends on average per week to shareholders.
So if someone wanted to get some of that money, what would they need to do?
Getting ready to invest
The short answer is that they would need to own some dividend shares. Doing that requires a physical way to buy and hold shares, such as a share-dealing account, Stocks and Shares ISA or trading app.
They then need to put money into it, whether as a lump sum or through ongoing contributions. How much will depend on what their passive income target is.
Aiming for £500 of monthly dividends
Imagine their target is £500 of dividends a month. That works out at £6k a year. You can calculate how big an ISA would need to be to try and hit that goal, based on its dividend yield. Yield is basically how much you expect to earn from dividends annually, expressed as a percentage of what you paid for the shares.
Say someones targetting a 6% average yield – a little over double the current FTSE 100 average, but still realistic in today’s market while sticking to proven blue-chip companies, I reckon.
That would require an ISA worth £100k. Perhaps someone has that money sitting spare in an ISA. But they could otherwise build to it at their own pace (and bearing in mind the annual ISA contribution allowance).
One way to speed things up would be to reinvest dividends at first so the ISA gets bigger, rather than taking the dividends out as cash from day one. That is known as compounding and can be a powerful accelerator when it comes to building passive income streams.
Building a portfolio of high-quality shares
I mentioned a 6% target yield above. As that is an average, not all of the shares in the ISA need to offer that high a yield, as long as overall the average is 6%.
One important thing to understand is that a dividend is never guaranteed. Guinness brewer Diageo recently slashed its dividend for the first time in decades. Indeed, it had been growing its dividend per share annually for over 30 years until last year.
That means it is important to choose carefully when deciding what shares to buy, but also to balance the ISA across a range of different shares and business sectors instead of putting all your eggs in one basket.
A share to consider
One FTSE 100 share I think merits consideration right now is cigarette maker British American Tobacco (LSE: BATS). Some investors shun tobacco shares for ethical reasons, but others may have concerns on financial grounds. Cigarette use is in structural decline and British American Tobacco’s cigarette sales volumes have been falling sharply. That is a risk to profitability.
But a strong brand portfolio gives it pricing power. The company has long experience managing declining demand and regulatory complexity.
The company has a lot of debt. However, it remains a cash generation machine. Like the Diageo of old, it has raised its dividend per share annually for decades – and plans to keep doing so.
