Most people view the stock market as one of the best ways of growing wealth. But it can also be one of the most effective ways of generating a second income, potentially even taking investors towards financial independence, where passive income covers expenses.
Even if only investing smaller amounts, by choosing quality companies, investors can make their money work significantly harder than in a savings account, utilising the power of dividends paying shares to reliably grow income.
Building passive income with dividends
For those new to the concept of dividends, think of them as a reward for holding onto each share of a company, paid in cash usually once a quarter. Companies might decide to use their earnings to pay a dividend to attract new investors. Whereas others opt to reinvest this to further grow the company.
The average yield of a dividend in the FTSE 100 (the UK’s top 100 companies) is 3.57%, meaning that by investing £1,000, an investor would expect to receive £35.70 per year in dividends. This cash pay-out would be in addition to any growth in the value of the shares owned. This means there are two potential ways of growing net worth within the one investment!
Investors need to be confident that the company’s share performance is also satisfactory. Otherwise, the dividend may simply be offsetting a decline in the value of shares investors own.
I am a huge fan of owning shares in the companies we use every day. If investors can be using dividends from these companies to be supporting daily spending, then there is a meaningful shift from simply being a customer towards seeing the real benefits of owning a share of the business.
As an example, assume an investor spends the UK average of £107 a month on petrol for their car. If this investor were to own £3,000 worth of shares in BP with a dividend yield of 3.83%, they could receive a free month per year of fuel with the approximately £114.90 paid out each year in dividends.
This could be done in a comparable way with utility providers, banks, or favourite shops, all with the aim of building a passive income that can eventually cover spending, allowing investors to use their primary income for the things they really enjoy!
My 2023 passive income plan
I am looking to cover £1,000 of my monthly expenditure with passive income in 2023, mostly in the form of dividends. To achieve this, I am going to need a 5% dividend yield from my investments. This should be achievable given the number of quality companies on the market.
When looking for a high-quality dividend paying company, I always want to see the following:
- Strong cash reserves and healthy cashflow;
- Long term earnings growth expected;
- Low debt to equity ratios (below 2);
- Strong track record in growing dividend yield (over five years);
- Healthy company fundamentals in a strong sector;
- A realistic and sustainable dividend yield (3-5%).
Dividend-paying stocks have a place in most investors’ portfolios, but especially for those who want to generate a passive income. In 2023, I am going to grow the percentage of my expenses that are covered by dividends from the quality companies I use every day, and get steadily closer to financial independence.