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One way to try and earn passive income is to buy dividend shares.
Dividends are payments to shareholders a company makes with some, or all, of its spare cash. Not all companies pay dividends, even if they have done in the past. So it is important for an investor to build their portfolio carefully when trying to build income streams.
With the right approach and patience, I think an investor could realistically target a monthly passive income averaging £1k.
Dividend shares can be lucrative!
To estimate how much an investor might receive each year in dividends, they can multiply what they invest in shares by their average dividend yield.
For example, that £1k a month would add up to £12k a year. £12k is equivalent to the passive income earned on £240k invested at a 5% yield. At a higher yield of 7%, it would require a little short of £172k.
7% is over double the current yield of the FTSE 100. But with a diversified portfolio of carefully chosen shares, I see it as a realistic target.
How to get started
First, of course, one needs an ISA.
There are lots of options available on the market, but each come with their own cost and fee structures. That could eat into passive income streams – perhaps significantly over the long term.
So I think it makes sense for an investor to take some time to decide which Stocks and Shares ISA may suit their own needs best.
Building up from nothing
Still, using my example above that requires around £172k, how might an ISA work?
After all, the usual annual contribution allowance is £20k.
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This is where compounding (basically, using dividends to buy more shares and earn even more dividends) can help.
Starting with an empty ISA and putting in £20k per year, compounding it annually, after seven years it ought to be worth around £173k.
At a 7% dividend yield, that is enough to generate over £1k each month on average in passive income.
Dividends are never guaranteed to last. But if the shares owned kep their payouts per share at the same level (or increase them), those passive income streams could go on for as long as an investor owns those shares.
One share to consider
As I mentioned above, such an approach presumes a portfolio diversified across different companies. That helps to reduce risk if one company does badly – and even the most brilliant business can run into unforeseeable difficulties.
One share I think investors should consider for its passive income prospects is Lucky Strike owner British American Tobacco (LSE: BATS).
Cigarette smoking is in significant structural decline in many markets. Clearly that poses a risk to both revenues and profits at British American.
Its portfolio of premium brands gives it pricing power, though. So the FTSE 100 firm can raise prices to try and mitigate declining sales volumes.
Although volumes are falling, they remain huge and I expect that to remain the case for many years. British American shifts over 10bn fags in a typical week.
Meanwhile, it has been growing its non-cigarette business in recent years.
Will that be enough to help continue its track record of raising its dividend per share annually for decades?
Only time will tell.
For now, though, with its 5.8% yield, British American continues to offer investors a strong passive income story, in my view.
