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I see a lot of chatter on the internet about how to earn money without spending too much time on it — otherwise known as ‘passive’ income.
Having tried a couple of different strategies, I’ve learned that owning a portfolio of shares delivering consistent dividends is one of the easiest ways to generate regular income.
Here are a few things I look for when investing in dividend shares for passive income.
Searching for high-yield stocks
Number one on the list is a high dividend yield. A stock’s yield is a function of both its cash payout and its current share price.
Of course, this means that a beaten-down share price can look attractive from a yield perspective. That’s why it’s important to analyse share prices over time to understand what the real story is.
I also look at a company’s payout ratio, being the percentage of its earnings that it pays out to shareholders. A consistent payout ratio and consistent dividend generally indicate stability and a shareholder-friendly approach from the board.
Finally, I’d want to see signs of future earnings growth. If earnings are stagnant or declining, that doesn’t bode well for the company’s future dividends.
Rio Tinto (LSE: RIO) is one dividend stock on my radar right now. The mining stock has a 6.5% dividend yield, which is well above the FTSE 100 Index average of around 3.5%. Throw in a price-to-earnings (P/E) ratio of 8.8 and it certainly seems like one for investors to consider.
Rio is one of the world’s largest miners and has a rich history as a consistent dividend payer. The Australian dual-listed company paid a £1.76 final dividend to shareholders in April after reporting underlying earnings of $10.9bn (£8.2bn), down 8% on the prior year.
Despite a more challenging year driven by iron ore prices falling 11%, the company paid out £6.5bn in dividends to shareholders — maintaining its 60% payout ratio for a ninth straight year. Considering the current geopolitical climate and a weaker Australian dollar, making Rio’s exports relatively cheaper, the stock could be a valuable addition to a diversified portfolio.
That said, the potential for a global trade war is a potential dampener on Rio’s outlook. If we see global growth slowing, or even a potential recession, demand for minerals would likely fall and hit Rio’s revenue, as would a further fall in mineral prices.
Generating passive income
Consider Rio’s current yield: £10,000 invested today would be expected to generate £650 in passive income for the year, all else being equal.
If you assume the yield remains constant for the next decade (whihc it probably won’t), and those dividends were reinvested, that same investor could be sitting on a portfolio worth nearly £19,000 with over £1,000 in annual income. After 30 years, the magic of compounding continues with those figures rising to over £4,000 on a portfolio worth nearly £70,000.
Of course, capital gains and losses over time will impact on returns. That’s especially the case with mining stocks that tend to be more cyclical, rising and falling in response to changes in the economic climate.
I’m not adding it to my own portfolio just yet as I’m already fairly diversified and don’t have the spare cash. However, I think Rio is worth a closer look for anyone building a passive income strategy.
