What makes a great passive income idea?

A lot of people like the idea of earning money without having to work for it. I think buying shares in blue-chip companies can be a very powerful yet practical passive income idea.

The income comes from dividends paid by the company to its shareholders. But some businesses do not pay dividends, others reduce their amount sometimes and some companies scrap them altogether.

Those are not random choices however. So here is what I look at when searching for shares to buy in the hope of generating passive income streams.

Spare cash and an enthusiasm for dividends

To pay dividends over the long run, a company needs to generate more cash than it needs.

That is not the same as generating lots of cash. Many businesses do just that. But often they will then put it back into the business, paying for research and development, promotional sales activity or expansion, for example.

On top of that, I look for businesses that not only generate lots of spare cash but are happy to pay it out as dividends, rather than hoard it. That can be a conclusion I draw from their behaviour. Some companies also explicitly set out their dividend policy.

Enduring relevance and market size

One such company is Legal & General (LSE: LGEN). The FTSE 100 financial services provider has announced plans to reduce the growth rate of its dividend. Still, it expects to keep increasing the payout annually, as it has for the past 15 years except for one year during the pandemic when it held it flat.

I own other shares that also have a long track record of dividend increases, such as British American Tobacco. But one risk with owning shares in a tobacco company is that declining smoking rates will hurt sales and profits.

By contrast, I expect demand for the sort of retirement-focused financial services, in which Legal & General specialises, to stay high for decades to come.

Pricing power

A big market does not equal a passive income machine however. It could be crowded and companies may even lose money, for example because they have to compete on price.

So when looking for dividend shares to buy, I ask myself whether a company has pricing power. That can come from its competitive advantages.

For example, Legal & General has a strong brand that helps it attract clients. It also has a large existing customer base. I see that as a competitive advantage because changing pension providers can be a hassle. So once a customer invests with a firm, price rises may not put them off sticking with the firm.

Valuation always matters

Legal & General faces risks, of course. All shares involve some risk. If there is another sharp market downturn that frightens policyholders they may cash in holdings, hurting profits. That was the backdrop to the last dividend cut in the firm, back in 2008.

On balance though, I like it as a business and think the 9.6% dividend yield is compelling. I bought it not just because of the passive income potential but also because I found the share attractively valued. Even when focused on dividends, it is important not to overpay for a share.

The post What makes a great passive income idea? appeared first on The Motley Fool UK.

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C Ruane has positions in British American Tobacco P.l.c. and Legal & General Group Plc. The Motley Fool UK has recommended British American Tobacco P.l.c. 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.