Going out to work every day can be tiring but the benefit is that it pays. Some people work even harder to earn a second income. I like the idea of earning more money but not necessarily the work that often goes with it. That is why I am building passive income streams by buying dividend shares.
That approach does not require me to have a lot of money when I begin, unlike some passive income schemes. Here is how I could go about it by putting aside just £5 each day.
Start saving on a habitual basis
If I just try to put money aside when I have some spare cash, guess what might happen when Christmas comes or an unexpected expense pops up? I could stop saving for a while. Before you know it, my positive financial intentions may be a thing of the past.
That is why I would try to get into a regular habit of saving.
Focus on income generation
As the money grew, I could learn more about shares and how the stock market works. The point of doing this is that it could help me understand what sorts of shares would help me build a second income over the long term.
The answer to that may seem obvious: shares that pay dividends. But not all shares pay them – and those that do may not in future. So I would focus on the source of dividends – profits and cash flow.
A company that has a competitive advantage in a resilient industry should be able to produce significant profits. I see Vodafone as a possible example thanks to its large installed customer base.
From profits to dividends
But I also look at whether a firm may need to use its profits for something other than paying dividends. For example, Vodafone has a large debt pile. Servicing that could mean it decides to cut its dividend, as it has done before, or even cancel it altogether.
So I also look at a company’s net debt. That helps me consider whether the firm may need to spend lots of money to keep its business relevant in future, for example by building new infrastructure or developing novel technologies.
If the company is set to be profitable and I think could use that money to pay dividends, I would consider whether it suits my portfolio. As well as profits, which are an accounting term, I look at cash flow. That shows the hard cash coming in (or out) of the door each year.
Building my second income stream
Whether I invest also depends on the firm’s share price. I think Diageo is a good company, for example, but its current share price relative to earnings is too high for my tastes.
I then consider dividend yield, which tells me what dividends I can hopefully expect as a percentage of the money I invest. £5 a day is £1,825 a year. If I invest that in shares with an average yield of 5%, I should be on course to earn just over £90 in dividends the following year. I could build my second income stream from there!
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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended Diageo and Vodafone. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.