In an uncertain economy, setting up a second income could offer me some additional financial security.
Buying shares I hope will pay me dividends while I own them is one way I could aim to set up such an income stream. If I had a spare £18,000 of savings today and was willing to put it in the stock market for the long term, here is how I would aim to earn £10,000 per year in passive income thanks to the magic of dividends.
How dividends work
Basically when a company makes money it has some choices as to what to do with it.
For example, it could spend the money to try and grow or maintain trade, by investing in a new factory or training staff. It could pay down some debt. But it may also decide to distribute spare cash among shareholders in the form of dividends.
That is exactly what FTSE 100 companies like British American Tobacco and Diageo do. Indeed, both have raised their dividends annually for decades.
But, just as future sales are never a sure thing, neither are dividends. That is why when it comes to investing with a second income as my goal, I would spread my portfolio across a number of companies. Rather than just looking at what dividend a firm pays today, I would consider the quality of the business and how much free cash flow I think it may generate in future.
Finding shares to buy for income
To make such a forecast, I follow legendary investor Warren Buffett and stick to companies I understand.
By looking at its annual report and financial statements (which include a statement of cash flows) I can try to get a sense of how a business has been doing. I can also use my own judgement in assessing what I think it might be able to achieve in future.
I used to own shares in Google parent Alphabet and still think it has strong prospects. But as it currently reinvests profits in growing the business, the company does not pay dividends.
By contrast, I own British American Tobacco in my portfolio. Its mature business means it can use its large free cash flows to fund dividends. That might not last though. The company has a lot of debt and profits could fall as cigarette smoking declines in many markets. That is where taking a view on how a company seems likely to do in future can help me as I choose dividend shares to buy for my portfolio.
Aiming for that £10k annual payout
My £10K target is ambitious even if investing in companies with a yield of around 8%, like British American Tobacco.
Investing £18,000 at an average yield of 8% should generate a second income of £1,440 annually. That is far off my target.
However, I could compound those dividends — that is, reinvesting them and using them to buy more shares.
I know that my returns will not be guaranteed, but assuming my portfolio continues to deliver, after 25 years my portfolio ought to be generating over £10,000 annually in dividends. That would mean I had hit my second income target, with a total cash outlay of £18,000.
