How I’d target passive income with £40 a month

Money that comes in without work? That’s known as ‘passive income’ — and it’s not as unlikely an idea as it may sound. From rent payments to artistic royalties, all sorts of passive income streams are regularly paid to millions of people. Among my favourites are dividends. By investing in dividend shares, I can benefit from the success of large companies.

It doesn’t take a lot of money to begin, either. Here’s how I would aim to target passive income in three steps, putting aside just £40 a month.

Start saving

For most people, £40 a month is an affordable amount of money to put aside each month. It may mean cutting out on some treats, but with focus, £40 a month in savings is doable for many. It’s around a tenner a week, less than the cost of a daily fancy coffee.

One benefit of putting aside a set amount each month is that it gets one into the discipline of saving. It’s possible to squirrel away more in a flush month, of course. I also think it’s useful because it allows time to learn more before investing. It would take a few months of saving £40 a month before I had a substantial pool of capital to invest. That would allow me time to study the stock market in detail and figure out what sort of dividend shares might best meet my passive income objectives and risk tolerance.

Make a shortlist of UK dividend shares

My next step would be to make a list of dividend shares that appealed to me. Here I wouldn’t necessarily be looking for the highest dividend yield. I’d also largely ignore the prospect of share price increases. That would be welcome, but if passive income is my objective, then in selecting shares I’d focus on dividend potential.

I’d try to select shares with dividends well covered by the company’s free cash flows. Free cash flow is the cash a company gets in a year once its costs are paid. I see it as a better indicator of a company’s ability to pay dividends than earnings, as earnings are an accounting concept and so don’t necessarily reflect the company’s cash flow. Ultimately it’s cash that funds dividends.

I’d also focus on companies which I think could keep generating free cash flows far into the future. That’s why I’m comfortable holding a company like British American Tobacco in my portfolio for its passive income potential. Smoking is declining in many markets. But pricing power and a push into non-cigarette products give me confidence that the company could keep generating substantial free cash flows in years to come. When it comes to dividends, I consider long-term free cash flow as king.

Turn on the passive income tap

With my shortlist in hand and capital growing from my monthly contributions, I’d be ready to invest in some shares. I’d likely buy through a Stocks and Shares ISA. Then I’d wait, hoping for passive income to come in. 

I would seek to diversify between different companies to reduce my risk should one of them disappoint. Dividends are never guaranteed. Holding shares in a few different companies across different industries would limit the impact on my passive income streams of any one company I held cutting its dividend.

Christopher Ruane owns shares of British American Tobacco. The Motley Fool UK has recommended British American Tobacco. 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.