With the cost of living rising, wouldn’t it be nice to earn some passive income? I certainly think so. There are multiple ways to earn some extra money, but one of my favourite options is owning dividend shares.
They tend to distribute income to shareholders regularly. And some have been doing so reliably for many years.
The FTSE 100 index holds many high-yielding shares. On average, this large-cap index offers a dividend yield of 3.7%. But some shares offer as much as 18%.
Passive income stocks: our picks
Do you like the idea of dividend income?
The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?
If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…
Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.
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Investing in dividend shares
There are certainly some pitfalls that I’d watch out for though. Not all dividend shares provide sustainable income. I prefer those that can comfortably pay out from their earnings, and I’d avoid any that resort to borrowing money to pay dividends.
Also, a very high yield could be hiding a temporarily depressed share price. Or the dividend could be at risk of being reduced.
Overall, I prefer my dividend shares to yield between 5% and 10% a year. I also look for a dividend cover of more than 1.2. That’s a commonly used measure of how many times a company’s dividend can be paid from its earnings.
Distributing dividends over many years is another factor that highlights reliability. I’m far more confident in a share that has paid out income over a decade versus one that only just started recently.
Compounding dividend income
When looking for a reliable second income, I try to look at more than just the dividend aspects. In addition to receiving regular dividends, I also want the value of my investments to rise over time.
For example, if my investment gives me 6% a year in dividends, and its share price rises by 5%, I’d earn a total return of 11%.
If I didn’t need the income now, I could benefit further by reinvesting the dividends. For instance, I could take the 6% a year in cash and buy more shares. In turn, these new shares would also pay dividends.
Repeating this process is called compounding and it’s a powerful technique that popular investor Warren Buffett used to turn millions into billions.
But what if I want to take my dividends as income every year? That’s possible too, and it’s something that I currently do for some of my dividend shares.
Top income shares
If I was investing £5,000 for dividend income right now, I’d buy Taylor Wimpey, Phoenix Group, Rio Tinto, Legal and General Group, and British American Tobacco.
This group offers an average dividend yield of 8%. It also features a dividend cover of 1.8, and 19 years of consecutive payouts.
That all sounds appealing to me.
Another reason for picking these shares is their potential to grow. All five businesses are established and benefit from strong positions in their respective markets. Lastly, each stock operates in a different sector. That provides me with diversification, and prevents me from putting all my eggs in one basket.
