There are myriad ways to try and earn a second income and a common one involves investing in dividend shares.
As an approach, it has some pros and cons: it requires money and the dividends are never guaranteed, but it can be lucrative and allows investors to benefit from the hard work and success of well-known companies.
So say someone had a £20k ISA and wanted to use it to try and build a second income. What might be a realistic expectation?
Targeting a four-figure yearly income
That would depend in part on the average dividend yield they could achieve. Yield is basically how much an investor earns in dividends each year, expressed as a percentage of what they pay for shares.
So for example, on a 5% yield, £20k ought to generate a £1k annual second income. That is not guaranteed though, as dividends never are. Indeed, that is why smart investors choose carefully and also spread their investments over different shares — £20k is ample to do that.
As well as yield, timeline matters. Investing £20k today at a 5% yield, the annual second income would be £1k. But for an investor prepared to wait, they could reinvest the dividends initially – something known as compounding.
Doing that for a decade, the ISA ought to be worth over £32k. At a 5% yield, that could generate yearly second income of around £1,629.
What’s a realistic yield?
In this example, I used a 5% yield as an example. In reality though, that is higher than both the FTSE 100 and FTSE 250 currently yield. Still, I think it is a realistic target in today’s market.
Some investors earn a higher yield than that, in fact, though others earn less.
The key thing, as I see it, is not to focus too much on yield alone, as dividends can come and go. Instead, I think it is important to consider companies’ likely future free cash flow generation potential and assess how much importance they attach to dividends.
Doing that can involve digging into company accounts and getting to grips with their business prospects.
Here’s an income share I think’s worth considering
I said that I think a 5% yield is a realistic target in today’s market. One FTSE 100 share I think merits consideration for its second income potential is financial services company Legal & General (LSE: LGEN).
The share currently yields 7.2%. Legal & General has grown its dividend per share almost every year since the aftermath of the 2008 financial crisis and aims to keep growing it annually, though whether it can do so of course depends on business performance.
It has a large customer base and proven business model that has been excellent at generating excess cash to fund dividends.
I do see a risk given current market turbulence. That could lead to policyholders withdrawing money, hurting fee income and profits. It is no coincidence that Legal & General’s last dividend cut was during the financial crisis.
But with its profitable business model in an area that benefits from high long-term customer demand, I believe Legal & General merits consideration.
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Christopher Ruane does not hold any positions in the companies mentioned.
This story originally appeared on Motley Fool
