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When it comes to passive income, I think sometimes simple can be best.
Sure, I could try to start my own business and then expect to make money without doing anything for it. But many other people already run proven and highly successful businesses.
By investing some money into purchasing shares of such companies, you could hopefully earn passive income in the form of dividends.
Putting money to work in the stock market
To illustrate the principle, imagine that I have £8,900 left over that I can invest. Everyone's financial circumstances are different, but the general principles below apply even for a different amount.
I'd like to invest that in stocks that I think could pay me some of their additional cash flows in the future, in the form of dividends.
stocks that have paid dividends before may stop paying them, and companies that have prospered before may fall on hard times. So I would diversify my £8,900 into a few different stocks.
However, before you do that, you would need a way to buy and sell stocks. So, you would start by setting up a shares trading account or stocks and Shares ISA.
Find stocks to buy
With passive income as a goal, I would like to reduce the risk of buying stocks that stop their dividend. So I would pay close attention to what I was investing in.
An example of the type of income share you would purchase is Dunelmo (LSE DNLM), one that I don't currently own but would be happy to buy if I had extra money to invest.
The reasons I like Dunelm's passive income prospects help show what I'm looking for.
First, I look for a market that I hope will benefit from strong and sustained demand. I think that's true in the home goods market that the retailer operates in. Next, I look at whether a company has a competitive advantage that can help it differentiate itself. Dunelm's network of stores and unique own brand products tick that box for me.
But remember that I want proven businesses, not just promising ideas. Dunelm meets the requirements again. It has been consistently profitable, earning £152m last year. That was a drop from the previous year. An ongoing risk I see is a weak economy leading consumers to cut back on non-essential household purchases, which will hurt Dunelm's sales and profits.
At 14 times earnings, I consider Dunelm shares to be fairly valued. The dividend yield is 4%. But the company usually pays special dividends in addition to the ordinary ones used to calculate that return. Last year's dividends per share are equal to 7.9% of the current share price.
Take a long-term approach
Even if you could invest the £8,900 in a diversified portfolio of shares with an average return of 7.9% (well above the FTSE 100 and FTSE 250 averages), that would earn me £703 a year.
This is well below the £3,360 I would need annually to reach my monthly passive income target of £280.
But as a long-term investor, my approach would be to reinvest the dividends.
If, by doing that, I could compound my portfolio at 7.9% each year, after 20 years I should reach my goal.
