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Earning a second income does not necessarily mean going out and taking on a second job. A less time-consuming approach that many people use is buying shares that pay them dividends.
Here, I walk through the basics of that approach and show what sort of income £9k in savings might be able to generate.
Dividends can be a useful income source
When a company generates more money than it needs, it has a few choices. It might save it, it could reinvest it in the business, or it could use some or all of it to fund a dividend for shareholders.
As the explanation suggests, dividends are never guaranteed. A company needs to be able to both fund them and choose to do so.
But they can be very lucrative. This year alone, just the FTSE 100 firms on the London market are expected to distribute around £88bn in dividends. Long-term investors may already have been receiving them for decades.
Some businesses, like Guinness-owner Diageo and British American Tobacco (LSE: BATS) have grown their dividend per share annually for decades.
The importance of yield… and power of compounding
British American Tobacco has a dividend yield of 7.6%. That means for every £100 invested today, an investor would hopefully earn £7.60 in dividends annually.
In reality, it could be more. British American has announced plans to maintain its annual dividend growth. But whether it can do so depends on business performance.
One reason its yield is high (over double the FTSE 100 average) is that investors perceive the risk of falling cigarette sales hurting profits – and leading to a dividend cut. Rival producer Imperial Brands did just that in 2020, although it has since started growing its dividend again.
So 7.6% of £9,000 would be £684 a year, or £57 a month. Instead of drawing that second income immediately, an investor could reinvest (compound) it to grow a bigger portfolio. That ought to lead to a larger second income for the patient investor.
After 10 years, such an approach would be earning around £119 a month. If the investor waited 20 years before drawing the dividends as a second income instead of compounding them, the monthly reward would be £247.
Finding shares to buy
Although British American’s yield is high, I think an average 7.6% yield is achievable in today’s market, even when sticking to proven blue-chip businesses.
Diversifying across different shares is important, to reduce risk.
British American does demonstrate a lot of what I look for when finding shares to buy for my portfolio, which is why I own it and think it is worth others considering.
For example, it has a large target market. Cigarette usage may be declining in many nations, but it remains significant – and other tobacco formats have been growing in popularity.
The company has a portfolio of premium brands such as Lucky Strike. That gives it pricing power, meaning it can push up prices without losing lots of sales volume by doing so.
That helps generate sizeable free cash flows which, in turn, fund dividends – and my second income as a British American shareholder.
This story originally appeared on Motley Fool
