Putting money into dividend shares today could help me set up passive income streams for years or even decades to come.
But not all shares will end up being equally lucrative. Some may maintain their dividends over time, while others will cut them. Some payouts will get bigger and bigger.
So if I had a spare £10,000 to invest in the stock market now and wanted to target a four-figure annual income down the line, what dividend shares would I buy?
Going to the source
Rather than looking at the dividends a company currently pays, I would look at the source of its dividends. What sort of long-term potential do I see?
That is important because paying out a large dividend today does not necessarily bode well for a company’s future prospects. Rather, as an investor I want to find the sort of business I expect to throw off lots of spare cash for decades to come.
As an example, consider Unilever. Its products, like shampoos and bleaches, may not be glamorous, but they are household staples. While rivals exist, owning premium brands helps the company build customer loyalty and gives it pricing power. That can help the firm generate profits (€8.3bn last year, after tax) and pay dividends.
Building a good value portfolio
But simply finding a business with strong cash generation potential is not enough. Sometimes, a company makes big profits but keeps them inside the business rather than paying them out as dividends. An example is Google parent Alphabet.
Not only that, but I need to consider valuation. Buying a great company can still make a bad investment, depending on the price I pay. Unilever is good, but does it merit trading on its current price-to-earnings ratio of 20?
That valuation means the yield is 3.4%. I think that is fine, but there are other dividend shares I think are equally high quality that offer me a much more attractive yield.
In any case, whatever shares I decide to buy, as an investor, diversification is always important. With £10,000, I would invest in five to 10 different companies.
Targeting four figures
To earn £1,000 in the coming year by investing £10,000 in dividend shares now, I would need a portfolio with an average yield of 10%.
That is possible but it is high. There are not many shares I would regard as high quality and happily add to my portfolio that currently offer a 10% yield.
I would not compromise my standards, so realistically I would expect to build a portfolio yielding less than 10% to start.
But, over time, dividends can rise as well as fall. Buying into great businesses with promising growth prospects could help me benefit from that.
If I compound dividends, the money available to me for investing ought to grow without me needing to put any more in. That could hopefully help me hit my annual dividend income target of £1,000 down the line.
