Passive income is money one receives without working for it. One of my favourite passive income ideas is investing in UK dividend stocks.
Even starting with just a few spare pounds a day, here is how I would aim to generate a monthly passive income of £100 by buying dividend stocks.
Doing the maths
Monthly passive income of £100 equates to £1,200 each year.
Dividend stocks pay out money to shareholders as dividends. Let’s say that I put £120,000 into shares yielding 1% – that would get me exactly my target amount. If I invested it in higher yielding shares, I could generate the same income for less money. For example, at a 10% payout rate, I would receive £1,200 annually from just £12,000 of capital.
But a challenge is finding high-yielding but also high-quality dividend stocks. Sometimes a high yield is a sign the market expects a dividend cut. For example, a company may have a lot of debt, but also be very profitable. If it pays the profits out as dividends, the yield could be high. But one day, the board of directors may decide to start paying down the debt pile instead of declaring dividends.
That’s why I try to find dividend stocks that I think have strong business prospects. For example, I look for companies that tend to generate strong free cash flows.
I also want to pick companies where I think there are prospects of future profits. That matters because sometimes, when a company’s future profits are likely to crash – for example because a key patent expires – its share price tumbles. Using historical dividend data, the yield at that point can look very attractive. But in fact it’s a ‘value trap’ – once the profits fall, the dividend will be cut and future yield will be less than the historic yield.
Finding the shares
The good news is that there are actually quite a few large companies with strong business prospects which pay out a healthy dividend. For example, the insurer Legal & General pays 6.8%, investment manager M&G yields 8.1%, and utility National Grid currently offers 5.3%.
If I could find dividend stocks with an average yield of 5%, I’d only need £24,000 of capital to generate my monthly £100 of passive income. These FTSE 100 shares all pay more than 5%, so I might even need less capital. But I would make sure that I diversify across different companies and business sectors. That way, weaker performance or a dividend cut by one of my holdings would have less impact overall. Dividends are never guaranteed, no matter how good a company seems or what its dividend record is.
Moving to action
The easiest way to start earning passive income would be to start with the capital upfront.
But that isn’t necessary. I could also put away some money each week or month and gradually build up my invested funds. That would mean I would wait longer to hit my target of £100 in monthly passive income from dividend stocks. But it has the advantage of letting me start from where I am today, even with no capital or savings, and putting my spare cash to work when I can.
Christopher Ruane has no position in any shares mentioned. The Motley Fool UK has recommended National Grid. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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