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Who else wants to build a second income stream with FTSE 100 dividend stocks?

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Over the last few years, I’ve been working on building up a second income stream by investing in FTSE 100 dividend stocks. My strategy is not overly complicated and simply involves investing in companies that pay me regular cash dividends. 

So far, the strategy is working well, and I’ve received a higher amount of cash dividends every year since I began building the portfolio back in 2014. I figure that if I can keep contributing to my portfolio over the next 20 years or so, eventually, I’ll be able to live off my dividends alone.

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Want to learn more? Here’s a more detailed look at how I’m creating this income stream through dividend stocks.

High dividends

The first thing I look at when assessing a company’s dividend potential is its yield. This is calculated by dividing last year’s dividend by the current share price. Alternatively, I often look at the ‘prospective’ yield which uses the expected dividend for this year, instead of last year’s dividend, in the calculation.

I look for stocks that have higher yields than the market in general (the FTSE 100 yield is 2.8%), somewhere between 3.5% and 6%. A yield of 5% means a £1,000 investment can potentially provide me with a cash dividend payment of £50 (1,000 x 0.05) for the year.

Why not go for higher yields? Well, while a high yield (7%+) sounds attractive, I’ve learnt that often, companies with high yields are in some kind of distress. It’s best to steer clear of them and play it safe. Here are some examples of yields in my portfolio.

Lloyds Banking Group: 4.6%
ITV: 4.9%
BAE Systems: 3.5%

Sustainable dividends

After I’ve assessed a stock’s yield, the next thing I do is look at dividend sustainability. Essentially, a company needs to be able to comfortably afford to pay its dividend, otherwise, there’s a risk of a cut in the future, which could have a negative impact on my returns.

The best way to check for sustainability is to analyse the size of a company’s dividend payout per share (DPS) in relation to its earnings per share (EPS). This is referred to as dividend coverage. I like to see earnings of at least 1.5 times the dividend payout, although, ideally, the ratio should be closer to 2. Here’s a look at the dividend coverage of some of my holdings.

Schroders: 2x
Diageo: 1.7x
Legal & General Group: 1.5x

Rising dividends

Lastly, another key requirement of my strategy is that a company is growing its dividend. There are two main reasons I focus on dividend growth. First, if the stocks I hold are lifting their dividends regularly, then my income stream is likely to grow consistently and I don’t need to worry about inflation. Second, over time, a rising dividend tends to place upward pressure on a company’s share price. That means I can potentially benefit from capital gains too. Here’s a look at the three-year dividend growth of some of my holdings.

DS Smith: 52%
Aviva: 51%
Imperial Brands: 33%

So, that’s how I’m constructing a portfolio that can provide me with a second income stream. It’s not going to make me rich overnight, but I’m convinced that over the long term, dividends should help me achieve financial independence. If this kind of strategy interests you, take a look at the report below, which lists five FTSE 100 companies that all pay big dividends.

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Edward Sheldon owns shares in Lloyds Banking Group, ITV, Diageo, Imperial Brands, Schroders, BAE Systems, Aviva, Legal & General Group and DS Smith. The Motley Fool UK has recommended Diageo, DS Smith, Imperial Brands, ITV, Lloyds Banking Group, and Schroders (Non-Voting). 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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