Investing in shares that pay dividends is one way to earn a second income that does not involve working for it.
It can mean earning money thanks to the success of proven blue-chip companies with highly cash generative businesses.
Here, I will explain some of the practicalities.
Gauging the income potential
How big the second income will be depends on two key factors: the amount invested and the average dividend yield. Yield is the dividends earned annually expressed as a percentage of the price paid for the shares.
So for an annual second income of £12k (£1k a month), a 5% yield on £240k would do the job – or a 10% yield on £120k.
Now, 10% is higher than any FTSE 100 share pays at the moment. And 5% is above the FTSE 100 average of 3.6%, but I think it is achievable. In fact, in today’s market, I think a 7% yield is achievable while sticking to quality blue-chip businesses.
Slowly does it
Still, even at a 7% yield, the investor would require almost £172k to hit the £1k monthly income target.
A lump sum would be one way to fund the plan – but few of us have a spare £172k sitting around!
Fortunately, an alternative approach is to drip feed money into a Stocks and Shares ISA and let it compound. Investing £500 a month and compounding at 7% annually, the ISA would be big enough after 16 years that – still presuming a 7% yield — it could generate a monthly second income of £1k.
So a 40-year-old today could put £500 a month into an ISA and aim to draw a £1,000 monthly second income from 56 onwards.
A smaller contribution could work too, but it would take longer to build to the target.
One dividend share to consider
I said above that I reckon a 7% average yield is achievable in today’s market. One dividend share I think investors should consider for its second income potential is Lucky Strike owner British American Tobacco (LSE: BATS).
The business of making and selling cigarettes is highly lucrative as they are cheap to produce but can sell steadily for a high price. With its premium brand portfolio, global distribution network and extensive manufacturing footprint, British American has a proven business model that is highly cash generative.
In fact, it is so cash generative that the FTSE 100 company has a policy of aiming to increase its dividend per share each year. It has already done that for decades.
Can that last? Past performance is no guarantee of what comes next – and British American Tobacco is seeing shrinking demand for cigarettes. That threatens to eat into revenues and profits. It is already showing up in the form of lower cigarette sales volumes.
Still, British American has been developing its non-cigarette business. Despite the challenges, I think it is likely to pay a substantial dividend for years to come.
