Could buying shares that pay dividends be a lucrative way to build a second income?
It could – and for many people it already is. What does it take — and what sort of income might it generate?
The mechanics of dividend shares and passive income
Answering those questions requires some explanation about what dividend shares are and how they can work.
Shares can pay dividends, which are basically one way for a business to use some of its excess cash. Not all do though. Perhaps they do not generate enough excess cash, or do but choose not to spend it funding dividends – even if they have paid them in the past.
That helps explain why savvy investors spread their portfolio across a diversified range of shares and rather than just look at a share’s current payout, they try to gauge what they think it might pay in future.
How large a second income might be earned depends on how much is invested – and at what dividend yield.
Yield is basically the annual dividend earnings, expressed as a percentage of what the shares cost to buy.
Aiming for a four figure income
Say, for example, that someone earns a 5% yield. That is well above the current FTSE 100 average but, in my opinion, still well within the realms of possibility while sticking to proven blue-chip businesses.
Investing £100k at that level ought to earn a £5k second income annually. That could be done as a lump sum. Alternatively, it could be the result of drip feeding money in.
That could be £20k a year for five years – although if dividends are reinvested along the way, that timeline could speed up.
On the hunt for shares to buy
Given that dividends are not guaranteed, what sorts of shares might make sense for such a second income plan?
As I mentioned above, I think it is wise to diversify across a range of shares that look like they have strong dividend potential. For example, they may have a competitive advantage in an industry with resilient customer demand, and strong free cash flows.
It is also important not to overpay for shares. Even though a second income from dividends is the goal, the price paid matters. It affects the yield earned. Also, overpaying could mean an investment ends up resulting in a capital loss.
Here’s a share to consider
One share I think investors should consider for its income potential is British American Tobacco (LSE: BATS). Some investors may have ethical objections. Others may wonder whether the Lucky Strike maker can fend off the risk of falling cigarette sales eating into revenues, something that has already happened for a couple of years in a row.
I recognise that risk. But British American has decades of experience dealing with declining demand in some markets, combined with increasing regulation.
It is massively cash generative and its portfolio of premium brands gives it pricing power. Having grown its dividend per share annually for decades, the yield is now 5.2%. That is above the 5% target I mentioned above.
If it can successfully navigate the demand risk facing its industry – for example by increasing its non-cigarette sales – I believe the FTSE 100 company could potentially keep paying big dividends.
