There are different ways to earn passive income. One I like is investing in the shares of blue-chip companies that pay dividends.
I like that because it is genuinely passive and means I can benefit from proven cash generators rather than needing to start up my own income-generating enterprise. On top of that, the upfront costs can be tailored to meet my own financial circumstances.
Let me illustrate by walking through the steps I would take if I wanted to target a monthly passive income stream averaging £1,000.
The role of dividend yield
In some ways the easy part of this is doing the maths. £1,000 a month adds up to £12,000 annually. How much I would need to invest to earn that would depend on my dividend yield. If I could earn a 5% yield, for example, it would take £240,000. At a 10% yield I would need £120,000.
The good news is that I can start with what I have! Rather than investing a lump sum, I could simply begin by making regular contributions that match my financial circumstances, then building up to my passive income target over time.
Avoiding yield traps
So would I just go for the highest yielding shares I could find? No!
Yield is a snapshot based on current share price and dividend. But no dividend is guaranteed to survive. A yield trap is a share that has a high yield now, but later cuts its dividend.
So I would look at the source of a company’s dividends. As an example, consider my investment in Legal & General (LSE: LGEN). The business operates in an area I expect to see strong demand over the long run, namely financial services, with a focus on retirement-linked products such as pensions.
It has some competitive advantages that can help it do well, from a strong brand to a large customer base. Legal & General generates significant cash flows thanks to that model, enabling it to support a meaty dividend yield that currently stands at 9.2%.
Building the income streams
Will that last? Legal & General has cut its dividend in the past and this year signalled plans to reduce its projected annual growth in dividend per share (though that is still growth!). If a rocky market leads policyholders to cash in, that could hurt profits and free cash flows for the firm.
Still, balancing risk and reward, I am happy owning Legal & General shares. A 9.2% yield is high but in the current market I think I could comfortably target a 7% average yield while sticking to blue-chip companies with proven cash generation potential.
Doing that, my £1,000 monthly passive income target would require an investment of around £172,000 either as a lump sum, or built up over time through regular contributions. If investing regularly, I could still earn passive income along the way, albeit at a lower level than my ultimate target.
My first move would be to set up a share-dealing account or Stocks and Shares ISA I could use to put my plan into action.