Dividend shares can accelerate the path to financial freedom. After all, investing consistently in high-quality, dividend-paying enterprises can elevate an investment portfolio to generate a second income stream. And given sufficient time, it may even be enough to replace an entire salary. Here’s how.
Getting started
As with any income venture, some starting capital is required. And that means funnelling a chunk of an existing salary each month into an investment account to buy dividend shares.
Obviously, the more an investor can allocate, the better. However, establishing a second income stream will take time. And the process will only be extended if it’s disrupted by withdrawals along the way. That’s why it’s critical to only inject money that won’t be needed for at least the next three to five years.
Don’t forget there’s nothing worse than being forced to sell an investment early to cover living expenses. And that’s especially true when stock prices have temporarily plummeted on the back of a crash, or correction.
Finding top-notch dividend shares
While plenty of companies offer shareholder dividends, not all are sensible investments. Remember, dividends are an optional payment. It’s a method of businesses returning excess capital to investors that it has no better use for internally.
However, if the firm’s cash flows become compromised or an expensive project such as an acquisition is executed, shareholder payouts often end up suffering. And a once-thriving source of passive income can be extinguished. That’s why it’s critical to dig a little deeper.
One of the easiest ways to verify the sustainability of dividends is the payout ratio. This metric tells investors how much of a business’s earnings are being redistributed. It’s calculated by dividing total dividends by net income, which can be found on the cash flow statement.
Suppose the payout ratio is greater than 100%. In that case, it means the company is paying more in dividends than it’s actually making in profit. This is unsustainable and will likely result in an imminent dividend cut.
This may also be the case for payout ratios greater than 60%. Ultimately if a business is distributing the bulk of its profits, there may be little left over for internal investment, making it potentially prone to competitive disruption.
Replacing a salary
According to the Office for National Statistics, the average UK salary as of November 2022 is £621 per week, or £32,292 per year.
By carefully constructing a portfolio of high-quality dividend shares, investors can realistically achieve an annual yield of roughly 5% without taking on excessive risk. But this rate, to earn £32,292 per year, a portfolio would need to be worth £645,840.
Needless to say, that’s not pocket change. But thanks to compounding, reaching this milestone isn’t as impossible as many think. Historically, the FTSE 250 has delivered an average annual return of 10.6%. Assuming this performance continues (which is never guaranteed), investing just £500 a month into an index fund could potentially hit this milestone within 24 years when starting from scratch.
