Here’s how I’d invest £500 a month to aim for £78,237 a year as a second income

Relatively small investments each month can grow into a significant second income over the years through the power of dividend compounding.

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Generating a sizeable and sustained second income means more choices in life, in my experience. Perhaps a nicer place to live, holidays to far-flung destinations, and the chance to work less, or even retire early.

I have found no better way of doing this than investing in high-quality stocks that pay high dividends.

I then reinvest those dividends back into the stocks that paid them – ‘dividend’ compounding’, as it’s known. This is the same process as leaving interest paid in a bank account to grow over time.

Using this technique means that making a big second income is not out of reach. It requires only small investments being made regularly, as early as someone can afford to do so.

Dividend compounding in action

I started out with a few shares in M&G (LSE: MNG), and these are still paying very good dividends.

In 2022, it paid 19.6p a share, so with the stock at £2.19 it gives a yield of 8.95%.

There is every chance this may go higher, as 2023’s interim dividend was increased to 6.5p from 6.2p. If this was applied to the total dividend, the payment would be 20.54p. At the current share price, this would yield 9.4%.

Nonetheless, from £0 in investments at the start, £500 invested each month at an 8.95% yield will give me £919,904 after 30 years! This would pay me £78,237 a year as a second income!

Crucial to remember is that this is based on me reinvesting the dividends paid to me back into the stock.

How should stocks be selected?

I always aim to have around four or five stocks in my portfolio geared to providing my second income.

They all have three things in common. First, they pay a high yield. Second, their businesses look on an uptrend to me. And third, I think their shares look cheap compared to their peers.

M&G is a good case in point. Over and above its 8.95% yield, its H1 2023 results showed adjusted profits before tax increased 31% to £390m year on year. Analysts’ expectations were for just £284m.

The results also showed it is on track to generate £2.5bn of operating capital by the end of 2024. This on its own can provide a powerful engine for further growth.

Analysts’ forecasts are now for earnings and revenue to grow, respectively, by 39.6% and 118.6% a year to end-2026.

It has higher debt levels than I would like to see, though, with a debt-to-equity ratio of just over 2. A healthy figure is seen as being around 1 to 1.5. However, it was around 2.8 a year ago, so it is moving in the right direction, although debt remains a key risk to look out for.

Additionally, the shares look cheap to me, reducing the chances of a major price fall erasing my dividend gains.

Using a core basic metric, the price-to-book (P/B) ratio, M&G is trading at 1.3 against a peer group average of 4.1.

discounted cash flow analysis shows the stock to be around 43% undervalued at its present price of £2.19. Therefore, a fair value would be around £3.84.

This does not necessarily mean that the shares will ever reach that level. But it does underline to me that the shares look very undervalued.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Simon Watkins has positions in M&g Plc. The Motley Fool UK has recommended M&g Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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