Passive income is the holy grail of investing for many investors. And that’s achievable by investing in stocks that pay shareholders dividends on a regular basis.
So, let’s have a closer look at how we could generate £5,000 a year in passive income.
Sustainable yields
The highest sustainable yield on the FTSE 100 is around 8%. That’s my opinion. But these stocks don’t offer too much in the way of share price growth. The majority of the total returns will come in the form of dividends.
We want to invest in companies with sustainable yields. Over the last few months, we’ve seen what happens when companies can no longer afforded their stated dividends — just look at Direct Line Group.
One way to tell if a company has a sustainable dividend yield is by looking at the dividend coverage ratio (DCR). This tells us how many times a company can pay its dividends from its earnings over a year. Typically, a DCR of two and above is considered healthy.
But it’s worth remembering that some stocks may have strong and steady capital generation, but a lower DCR. These dividends could be just as strong as those from a cyclical stock that has a DCR above two.
8% yields
After the recent stock market correction, we’ve seen dividend yields in certain sectors push upwards. That’s because dividend yields and share prices are inversely correlated.
The sector which saw the most damage was financial stocks. Several stocks in this sector already offered attractive yields, but the downward pressure on share prices sent these yields upwards.
Among my favourites are Legal & General, Phoenix Group, Aviva, and Close Brothers Group. These stocks offer 8%, 9.2%, 7.5%, and 7.7% respectively. The DCRs, combined with cash generation data, suggest the dividends are relatively safe — of course, nothing is guaranteed when investing.
So, by investing in these four stocks, I could average an 8% dividend yield. But in order to achieve £5,000 a year in passive income, I’d need £62,000 in capital.
Compound returns
Some investors don’t have £62,000 in capital, but we can look to work up to it by using a compound returns strategy. Compound returns is a powerful investing concept that involves earning returns on both your original investment and on returns you received previously.
Essentially, I’m investing my dividends year on year and earning interest on my interest. And the longer I leave it, the more money I’ll have because the growth is exponential.
So, how can I get to £62,000 by investing in stocks with 8% yields? Well, if I started with £12,000, it would take me 20 years of investing and reinvesting in 8% yielding stocks to have £60,000. If I started with £30,000, if would take me nine years, and if I started with £40,000, it would take me just five years.
On reaching the magic £60,000 figure, I could start using that £5,000 a year in passive income to help fund my life.
This post was originally published on Motley Fool
