A second income provides an additional safety net against the unexpected things that sometimes happen in life.
It can also be used to build a better standard of living for ourselves and those closest to us.
The best way I have found of generating this additional source of income is buying high-quality, high-yielding shares.
Picking the right companies
There are three key points on my checklist for shares that I buy. I recently added to my holding in M&G (LSE: MNG) for these reasons.
The first thing I look for is an annual yield of over 7%. Why this figure? I can make 4%+ from buying the risk-free 10-year UK government bond, and shares are not risk-free.
M&G paid a total dividend in 2023 of 19.7p a share. This gives a yield of 9.8% on the current share price of £2.02.
This is one of the highest yields in any of the major FTSE indexes. By comparison, the current average yield in the FTSE 100 is 3.8% and in the FTSE 250 it is 3.4%.
Growth prospects?
The second thing I look for is a strong growth outlook for the firm. This is what powers gains in both share price and dividends over time.
A risk for M&G is its relatively high debt-to-equity ratio of around 1.9. Another is a genuine new global financial crisis.
However, its 2023 results showed a 28% rise in adjusted operating profit from 2022 — to £797m. Operating capital also rose — by 21% year on year, to £996m – taking the total to £1.8bn over 2022 and 2023.
Overall, consensus analysts’ expectations are that M&G’s earnings will grow at 18.8% a year to the end of 2026.
Undervalued?
The final thing I look for is that the share appears undervalued against its peers. This lessens the chance of a major share price slide wiping out my dividend gains.
In M&G’s case, it currently trades on the key price-to-book (P/B) stock valuation measure at just 1.2.
This looks very undervalued compared to the average 3.6 P/B of its peer group.
But how much of a bargain is it? A discounted cash flow analysis shows the stock to be around 48% undervalued against its competitors.
So, with the shares currently at £2.02, a fair value would be about £3.88, although it might never get there.
Turbo-charged dividends
Once I have bought a high-yielding share, I use the dividends paid me to buy more of the stock. This is called ‘dividend compounding’, and it dramatically increases the dividend payouts over the long term.
For example, £17,000 – the average UK savings account amount — invested at 9.8% would make £1,666 in the first year. After 10 years on the same yield, I would have another £16,660.
However, if I reinvested those dividends back into the stock, I would have made another £28,116 instead of £16,660.
After 30 years of doing this with an average 9.8% yield, I would have £317,753. This would pay me £29,548 a year in dividends or £2,462 a month!
Yields can go down as well as up, of course, depending on dividend payments and share prices.
However, given its strong business outlook, high yield, and undervaluation, I may well be adding even more shares to my M&G holding very soon.
