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Money sitting idle could instead be used to earn passive income. There are different ways to do that, but one common approach is to invest it in dividend shares.
With a long-term approach, this can potentially lead to sizeable ongoing passive income streams. As an example, here is how a £25k lump sum might end up generating £12k in income annually.
Weighing risks as well as rewards
You may wonder why I am using words like ‘potentially’ and ‘might’. The thing is, dividends are never guaranteed. Even a big, profitable firm that has been a generous payer can decide to axe its dividend.
However, it is possible to mitigate against that risk. For example, one simple but powerful move is spreading a portfolio over a few different shares. Twenty-five grand is ample to do that.
Rather than focusing too much on a share’s current dividend, an investor can choose to look at its business prospects. What hard cash is coming through the door each year — and how likely is that to continue?
For example, does the business benefit from a large addressable market and some competitive advantage that can help it do well in that market for years or even decades to come?
Building income streams
So how might £25k lead to someone earning an annual passive income of £12k? Presume it is invested at a compound annual growth rate of 7%. After 29 years, the portfolio will be big enough that a 7% dividend yield would equate to a bit more than £12k a year.
Twenty nine years may sound like a long time. It would be possible to start drawing the dividends as passive income sooner, but cutting the wait would also reduce the amount of dividends.
Finding the right shares to buy
Is a 7% compound annual growth rate achievable? I think it is. It is well above the FTSE 100 average dividend yield of 3.4%. But the compound annual growth rate is not just dividends, it also includes any share price gains.
By the same token, share price declines could eat into it. So it makes sense to buy shares not only because they have good dividend prospects, but also because they are attractively valued.
A share to consider
One share I think investors should consider for its passive income prospects is cigarette maker British American Tobacco (LSE: BATS). It has raised its dividend annually for decades and currently yields 5.7%. In the past five years, the British American Tobacco share price has surged 58%.
One reason British American has been able to raise its dividend like clockwork has been the massive cash flows generated by selling cigarettes.
Those remain huge – but there is a risk that declining cigarette sales could lead to smaller cash flows in coming years, potentially putting the dividend at risk.
Still, with its premium brands, large customer base and growing non-cigarette business, I reckon British American may continue to do well.
Putting the plan into action
That £25k is more than one year’s ISA contribution limit, of course. But a Stocks and Shares ISA could be used for this passive income plan if contributions were split over more than one year.
Or an alternative for putting the money to work in the market could be a share-dealing account or dealing app.
