Dividends are essentially a share of a company’s profits. But there are also various other ways a company might share profits with investors. For instance, it might reinvest cash to grow the business.
Some buy back their own shares to reduce the supply in circulation. This tends to result in a higher share price, over time.
So although dividends are an important part of earning income from shares, they’re not the only factor to consider.
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Targeting passive income
To target £1,000 a month in passive income means I’d need a pot of money large enough to withdraw £12,000 a year.
Much of that is likely to be from dividends, but some could come from a rise in the value of the underlying investments.
Over the long run, UK shares typically return around 8-10%, including dividends. That means I’d need to build a pot worth £120,000-£150,000, according to my calculations.
Taking the larger figure, let’s consider how I could build a pot of this size from scratch. First, I’d focus on filling my Stocks and Shares ISA. Currently, it’s possible to invest £20,000 a year within this tax wrapper.
I calculate that if I were to invest £20,000 every year in a basket of shares, I could reach my goal within just six years. That’s six years to effectively more than double the State Pension.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
To buy or avoid?
Next, I’ll need to decide which shares to buy and which shares to avoid.
Many FTSE 100 shares offer chunky dividend yields. For instance, Vodafone yields a whopping 11% right now. But a large dividend yield doesn’t automatically equate to a good passive income investment.
Note that Vodafone shares have lost investors 3% a year over the past decade, even after factoring in dividend payments.
When searching for which shares to buy, I look for profitable companies with growing sales and earnings. A dividend is important. But so is dividend growth. If earnings are climbing, I want to see some of that flowing through to dividend payments.
A solid dividend growth stock
If I had spare cash for my ISA, one such FTSE 100 share I’d buy is BAE Systems (LSE:BA.). With a 2.5% yield, it’s not typically known as a high-dividend share. But it has grown its payout for at least 20 years in a row.
In addition, it offers steady growth in sales and profits. Net profits have gained by 13% a year over the past five years.
BAE is benefitting from growing global defence spending which, in turn, was driven by conflicts in the Middle East and Ukraine.
It’s a global leader in aerospace and defence. And it has managed to obtain many large contracts that include building nuclear powered submarines to cybersecurity initiatives.
One potential risk over the coming year could be the impact of elections around the world. New leaders can shift the direction of foreign policy and this could impact defence spending.
That said, I think security challenges are likely to persist. And BAE Systems shares should offer a solid way to grow passive income over time.
