In the last few years, I’ve made a beeline for starting to generate a second income. And I’m not alone.
Investors have become more conscious about putting their money to work. After all, who can blame them when we’ve endured a spell of red-hot inflation?
With one eye on my retirement already, I could stash my cash away in the bank and take advantage of the attractive savings rates on offer. But to put myself in the best position to build wealth over the long run, I’m taking a different approach.
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Instead, I’m buying stocks with bulky dividend yields. The FTSE 100 average is 3.6%. I want to target stocks with a yield of 5%, or more.
The average amount saved in the UK is £11,000, so let’s use that as a base. Here’s how that could become a second income of nearly £20,000 a year.
What to buy
Before delving into the numbers, I want to give an example of what sort of income stock I reckon could be a smart buy today. One I own is British American Tobacco (LSE: BATS). The stock has a 9.6% yield. That’s way above the 5% benchmark I look out for.
Dividends are never guaranteed. So during events such as the pandemic when profits are squeezed, businesses can sometimes cut their payout. But that hasn’t been the case with British American Tobacco. For over two decades it’s paid a dividend. That’s a gleaming record that fills me with optimism that the business will keep rewarding its shareholders moving ahead.
I also like British American Tobacco shares because they look undervalued. They have a price-to-earnings (P/E) of 6.5. Their forward P/E is 7.1. Both of those are considerably below the Footsie average of 11. As such, I think its share price has plenty of growing room.
The risk of investing in the business is that it operates in an industry that’s coming under more scrutiny. There are more laws being introduced to regulate the tobacco industry.
But with its meaty yield and cheap valuation, I like the look of the stock.
How much could I make?
So how could my £11,000 turn into a significantly higher second income for retirement? If I invested that into British American Tobacco today with its 9.6% yield, I’d earn £1,056 a year in passive income. While I could use that to put towards things such as bills or holidays, I have aims of making more.
That’s where compounding steps in. By reinvesting the dividend payments I receive, I’m essentially earning interest on my interest. This is a method used by many investors to maximise gains.
If I were to do that with British American Tobacco, after 20 years I’d earn £6,790 a year, or £566 a month. That’s getting closer to where I want to be. But if along the way I could afford to invest a further £200 a month, by year 20, I’d make £19,821 a year, or £1,652 a month.
Of course, that’s reliant on its yield remaining the same, it could rise or fall during that time. I’m also assuming its share price doesn’t move.
However, what it does prove is that targeting high-yielding stocks and being patient can be a great way to build wealth and security for later life.
