When it comes to passive income, most people could learn a thing or ten from billionaire investor Warren Buffett. Buying shares on behalf of his investment vehicle Berkshire Hathaway over decades, he set up passive income streams that now earn the business billions of dollars a year.
In fact, converting the gains to GBP, Berkshire earns over £100 a second in passive income from dividends alone.
So even someone with just a few hundred pounds to spare can draw some inspiration when it comes to earning passive income.
Taking the long view
For example, I said Buffett built those dividend streams over the course of decades. Choosing to take a long-term approach to investing can pay off handsomely.
Say, for example, a share has a dividend yield of 5% and the investor chooses to reinvest (compound) it rather than taking it out as cash.
Compounding £250 at 5% annually, it should be worth over £400 after a decade and around £678 after 20 years. This approach has worked even better in some cases for Buffett, as shares he bought like Coca-Cola have increased their dividend annually for decades.
At any point, the investor could choose to stop compounding and draw any dividends as cash.
Focus on future free cash flows
When looking for shares to buy, investors sometimes focus on profits or how popular the business is. Those factors can play a role. Buffet typically focuses on profitable not loss-making businesses, while a business’s popularity, thanks to things like its brand or proprietary technology, can help give it a competitive advantage.
Buffett calls that a “moat” (it helps repel rivals) and his investment in Apple is an example of both factors at play.
But earnings are an accounting concept. They can include non-cash items. So when it comes to funding dividends, they are not necessarily a reliable guide to how a company might support its dividend.
By contrast, a company’s accounts provide a detailed breakdown of its cash flows. They show the hard, cold cash coming in and going out of the door. That matters when it comes to funding dividends.
It is important not just to assess current free cash flows, but also what they might look like in future. After all, dividends are never guaranteed to last.
Buy into brilliant businesses
Some companies can support a strong dividend for a while but have ropier long-term prospects.
One share I think investors should consider for its long-term passive income potential is ME Group (LSE: MEGP).
From Photo-Me booths to orange juice machines and garage forecourt laundrettes, the multinational company’s focus on vending machines is highly cash generative. It helps support a dividend yield that stands at 5.7%.
Not only that, but the current share price is just 10 times earnings. I see that as an attractive valuation.
Its huge network of vending machines gives the FTSE 250 company a competitive advantage. For a rival to set up an equivalent network would be prohibitively expensive. And that gives it a substantial moat.
Still, with fewer shoppers visiting high streets, there is a risk that physical vending machines could decline in usage over time. From a long-term perspective though, I like the proven business model and cash generation prospects.
