Image source: British American Tobacco
Whether it's an emergency fund or holiday savings, any leftover money could be used for passive income. As the saying goes: “Give every dollar a job“.
Basically, this means that money should be put to work instead of left collecting dust. Savings accounts rarely pay more interest than the rate of inflation, so money left in one often loses value.
Investing in the stock market provides the opportunity to beat inflation and harness the power of compounding returns. But it also carries the risk of losing money. That's why it's important to choose the right stocks.
dividend stocks
A popular method of earning passive income is investing in dividend stocks. Unlike growth stocks that rely on a rising price to generate value, dividend stocks promise regular returns. This makes it easy to build a portfolio that provides reliable income.
But dividends are not guaranteed. That's why it's important to look for a company with a history of consistent payments.
For example, consider British American Tobacco (LSE: BATS).
The tobacco giant's share price has fallen 49% since 2017 due to changing views on smoking. New health regulations have caused a drop in sales, forcing the company to adapt or die. However, developing less harmful and smoke-free alternatives to tobacco is an expensive task.
As for dividends, it checks the most important box, as it has almost three decades of consistent and uninterrupted payments. Another important factor is the yield, which determines the percentage paid as dividend per share. The higher the better.
The stock's yield is currently around 8%, which is much higher than the FTSE 100 average. An investment of £5,000 would generate £400 in dividends a year. If dividends were reinvested and held for 10 years, the fund could grow to £17,340 and pay £1,260 in annual dividends (assuming a 5% annual average price gain).
However, performance fluctuates with the share price, so it shouldn't be considered too important. A reliable payment history is the key factor to look for.
Other considerations
Of course, investing in a stock simply because it has a good dividend history does not guarantee returns. If the company is on the brink of failure, everything could go down the drain. By looking at the company's balance sheet and income statement, we can evaluate its financial stability.
British American is well established, with a market capitalization of £63bn and £28bn of revenue last year. But the cost of transitioning to less harmful products made it unprofitable by the end of 2023, with a £14bn impairment.
Recent half-year results show some improvement, with £4.4bn in profits despite an 8.2% drop in revenue. If the transition to next-generation smokeless products bears fruit, it should continue to do well. But it is still a significant risk.
Diversification
There are other dividend stocks to choose from that may have a more reliable business model. The downside is that they typically pay a lower dividend. For example, a pharmaceutical company GSK It has a very solid business model but only 4% profitability. Or utility company National Networkwith a yield of 4.4%.
I think it is important to create a diversified portfolio that includes several stocks from various sectors. This can help ensure stability while taking advantage of the potential returns that high yields offer.
