Using dividend shares to earn passive income is an idea that dates back hundreds of years. But it is more relevant than ever today, with British companies paying out large sums in dividends each month.

Curious how it might work in practice? Let me explain.

Dividends: the basis of the income

What are dividends? When a company generates spare cash it can decide what to do with it. That might be to save it for a rainy day or invest it in business growth.

But paying some or all of it out to shareholders is another option. This is what we call a dividend.

Dividends are never guaranteed to last. A company can find its business generates less spare money than before, or simply changes its priorities.

But, if it does generate money and pays it out as dividends, this is potentially a lucrative opportunity for an investor.

To reduce the risk from a dividend being cut or cancelled, the savvy investor will spread their portfolio over different shares.

Aiming for a target

The amount earned depends on the portfolio’s average dividend yield. Although the FTSE 100 yield currently sits a little north of 3% (meaning £3 of dividends annually per £100 invested), in today’s market I think a 6% yield is realistic while sticking to quality blue-chip companies.

At that level, earning an average £150 a week in passive income would require a £130k portfolio.

That could be a lump sum. Or someone could set up a Stocks and Shares ISA then drip feed money in, initially reinvesting dividends until the portfolio reaches the desired size. Such an approach is known as compounding and can be lucrative.

Compounding a £250 contribution a week at 6% annually, it would only take eight years to go from an empty Stocks and Shares ISA to one worth over £130k. That is big enough to earn £150 in weekly passive income at a 6% yield.

One dividend share to consider

One share I think investors ought to consider for its passive income potential is FTSE 100 financial services company Standard Life (LSE: SDLF).

Standard Life’s business focuses on retirement-linked savings and pensions. That is big business – none of us is getting any younger!

Over the years, Standard Life has consolidated a number of businesses under its umbrella. So around one in five British adults is now a client.

That gives the FTSE 100 firm economies of scale. Its large customer base is an asset and I also like its brands, deep expertise and business model that is proven to be cash generative.

One risk I see is the impact a wobbly economy could have on parts of Standard Life’s portfolio. For example, it has a mortgage book and some valuations could need to be written down if there is a property downturn.

But from a long-term perspective, I like the look of the business with its 7% dividend yield and stated aim of keeping its dividend per share growing each year.

Should you invest £5,000 in Standard Life right now?

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And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if Standard Life made the list?

Christopher Ruane has no position in any of the companies mentioned.