One of my favourite ways to earn passive income is buying shares in proven blue-chip businesses, then sit back and let the dividends roll in. As an example, here is how I would aim to generate an annual second income of £1,000 by making regular purchases of a specific FTSE 100 share.
How income builds up over time
The share in question has an 8.1% dividend yield at the moment. So if I invested £300 I would hopefully earn £24.30 each year in dividends (in fact, I could well earn more as this share is a consistent dividend raiser, as I explain below).
That means every £300 I put in ought to grow my passive income streams. One advantage of drip feeding £300 in each month is that I can buy at both low and high share prices, smoothing out my purchase price. This approach is known as ‘pound cost averaging‘.
One risk is overpaying, so if I felt the share price offered poor value, I might stop my monthly contributions until the valuation came back to a place I liked. But the theory of pound cost averaging is that it takes the guessing out of trying to time the market. That appeals to me, as market timing is not only notoriously difficult (if not impossible) to achieve consistently, it also sucks up a lot of effort.
Big yield, great dividend history
So which is the FTSE 100 share with an 8.1% yield I am discussing? It is one I already own, British American Tobacco (LSE: BATS). The size of my holding has changed over time, but I expect the share to feature in my portfolio for the long term.
With a 24% price increase so far this year, the share has grown substantially in value. Over five years though, it is 1% lower.
The appeal for me here is not growth. British American’s key market of cigarettes is in long-term structural decline.
Rather, I own the share primarily for its income potential. Making cigarettes is cheap, but British American can sell its premium branded puffs for a pretty penny. That has made it a huge cash generator, funding a dividend that has grown annually for decades.
The tobacco industry is risky, but still lucrative
That impressive record means British American is one of precious few FTSE 100 Dividend Aristocrats.
Putting in £300 each month at an average yield of 8.1%, within around three and a half years investors ought to be earning £1,000 in annual passive income. In practice, using pound cost averaging, I may get a different yield for each month’s purchase.
I manage my risks partly by keeping a diversified portfolio, of which British American is only one part. Dividends are never guaranteed to last, let alone keep growing yearly. While cigarette sales remain large (the firm sold 250bn cigarettes in the first half of this year), they look set to keep declining. Indeed, those fag sales represented a volume fall of 12.5% compared to the same period last year.
Still, the company has been expanding its non-cigarette business. If that investment pays off, I think its marketing and distribution muscle could help cash flows remains substantial.
This post was originally published on Motley Fool
