Passive income is money that comes in without working for it. But a lot of purported passive income ideas actually seem to involve a lot of work. That’s why investing in UK dividend shares is among my favourite passive income ideas. I can simply buy the shares, sit back, and wait for any dividends to arrive without having to lift a finger.
Here’s how I would start investing in UK dividend shares to target passive income streams.
Focussing on income
Different shares have various attractions. For example, I could invest in an area where I see rapid growth potential, such as buying shares in digital marketing network S4 Capital or tech giant Alphabet. But companies like that don’t pay dividends. Instead, they focus on growth.
That means they don’t match what I am looking for when it comes to passive income ideas. Instead, I would focus on companies that tend to pay out substantial dividends. Often those are companies in mature industries where growth prospects are limited. Rather than invest heavily in the business, they pay out surplus cash as dividends. Examples typically include tobacco companies and oil majors. Indeed, it is primarily for their income potential that I hold shares in companies such as British American Tobacco.
Finding the right dividend shares
But simply running one’s finger down the list of shares that pay out the highest dividends isn’t the best way to select the most suitable passive income ideas, in my view. Such dividend data tends to be based on historical data, which isn’t necessarily a guide to future performance. Last year, for example, many investors including myself got a nasty surprise when Shell cut its dividend for the first time since the Second World War. No dividend is ever guaranteed.
What matters is whether a company will generate enough free cash flow to pay out a dividend in years to come. So, for example, if a business finds its revenues declining, over time it may generate less free cash flow. That could hurt its ability to pay dividends. It may try to offset falling revenues by increasing prices to boost the profit margin. In fact, that is exactly the strategy of some tobacco companies these days. But while pricing power can insulate a company’s dividend from declining revenues for a while, in the long term if a company reports dramatically lower sales it will become increasingly difficult for it to sustain a dividend.
Hunting for passive income ideas
So then, how do I select UK dividend shares I can use as passive income ideas if not just by looking at the published dividend yield? I do some research into their annual reports and accounts to understand more about their future business prospects and what they could mean for free cash flow.
I also look at the attitude of the company towards dividends. Many companies have a dividend policy in which they set out their objective when it comes to future dividends. Although this is no guarantee of dividends, it does at least help me rule out some companies where management has already signalled doubt about maintaining a dividend.
Crucially, I diversify. Rather than concentrate my investments in one company or sector, I spread them over a diverse range of what I think are promising companies.
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Christopher Ruane owns shares in British American Tobacco and S4 Capital. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. The Motley Fool UK owns shares of and has recommended Alphabet (A shares) and Alphabet (C shares). The Motley Fool UK has recommended British American Tobacco. 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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