A growing number of people across the UK are looking to the stock market for help in creating a second income. With inflation still chipping away at pay packets and property markets shaky, dependable dividend shares can be a smart way to supplement earnings.
Done correctly, they could even pave the way towards early retirement.
But building a second income takes more than just picking the shares with the biggest yield. Over the years, I’ve developed three simple rules to keep my passive income strategy on track.
Only buy well-covered dividends
It’s tempting to chase the highest dividend yields, but that can be a trap. If a company’s paying out more than it earns, or burning through cash, the dividend could easily be slashed.
That’s why investors may want to consider Imperial Brands (LSE: IMB). As a tobacco company, it isn’t for everyone, but for others, I think its worth considering. It offers a generous 5.3% yield with a sensible payout ratio of 62%. Plus, it generates plenty of free cash — more than double its dividend payments — giving me extra confidence that those payments can keep flowing.
Valuation looks appealing too. Imperial trades on a forward price-to-earnings (P/E) ratio of just 9.7, suggesting the stock’s relatively cheap. However, it hasn’t exactly set the market alight this year, with the share price up 13% — less than half of key rival British American Tobacco.
Of course, there are risks too. Regulation remains a big one, with tighter anti-smoking laws potentially shrinking its market. There’s also a shift in consumer preferences, as more smokers quit or switch to alternatives like vaping, where margins are lower.
Diversify across industries
No matter how rock-solid a company looks, it’s never wise to rely on a single sector. That’s why I also look at different industries. Financial stocks, for example, often deliver attractive yields.
Legal & General‘s one of the FTSE 100’s highest yielders, currently sitting at 8.5%. The insurer has a proud history, with over 20 years of continuous dividends and four years of steady growth.
However, lately it’s raised some serious concerns. Earnings presently don’t cover the dividend fully, raising the risk of a cut if profits don’t rebound. Its balance sheet’s also under some pressure, with high debt compared to equity. Revenue and earnings growth have dipped lately, explaining why the share price has crawled just 11% higher over the past five years.
More cautious investors might prefer fellow insurers Aviva or Admiral Group, which offer slightly lower yields but stronger balance sheets and cheaper valuations.
Reinvest to grow faster
Finally, the quickest route to turning dividends into a serious second income is by reinvesting them. Buying more shares compounds the returns over time, setting up a bigger income stream down the line. It’s a straightforward habit that can make a huge difference over 10 or 20 years.
In my opinion, by sticking to these three simple rules — buying well-covered dividends, diversifying across sectors, and reinvesting payouts — anyone can start building a lucrative second income with FTSE 100 shares.
It may not happen overnight, but with patience, it’s one of the most dependable wealth-building tools out there.
