Dividend shares can be an excellent way to earn passive income. Many listed companies pay a portion of their profits to shareholders in the form of dividends.
But not all companies do so. Some firms reinvest profits to grow the business. To earn regular income though, I’d focus on dividend-paying shares.
Many of these can be found in the FTSE 100. That’s because this large-cap index holds many mature and established companies. These tend to be more focused on providing stable and consistent dividends rather than aiming to multiply the size of their business.
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Finding stocks to buy
To find the best dividend shares, I’d use a 3-step process:
First, I’d look for a high dividend yield. The average for the FTSE 100 is currently around 3.5%. That doesn’t sound compelling right now though. So investors may want to aim higher. That said, bear in mind that a double-digit yield might not be sustainable either. So where is the sweet spot? I’d look for a range of 5% to 8%.
Next, I’d find companies that have a history of paying reliable and consistent dividends. Many of the best dividend shares have been paying consecutive payments for decades. These sound far more reliable than ones that have just started.
Finally, I’d assess the company’s financial health. As dividends are typically paid from earnings, a healthy outlook for sales and profits is most welcome. Earnings should be large enough to comfortably cover dividend payments.
Spreading out my £20,000
Once I have a shortlist of shares, I can decide how to turn £20,000 into a second income stream.
I wouldn’t invest it all in just one or two shares. Instead, I’d diversify my portfolio across several stocks and different industries. This will help spread the risk and avoid putting all my eggs in one basket. That way, if one of my stocks underperforms, it shouldn’t impact my overall portfolio by as much.
Bear in mind that much can happen with companies over time. I’d need to monitor them to ensure they continue to meet my criteria. And if they don’t perform, then I’d consider swapping them for some dividend shares that do.
Which shares?
Some Footsie companies that currently meet my criteria include Phoenix Group, Legal & General, British American Tobacco, Rio Tinto and Sainsbury’s.
All five of these dividend shares operate in distinctly different industries. They don’t cover all of the sectors, but I’d say they are sufficiently diversified.
On average, this group offers a 6.7% yield and over 22 years of consecutive dividend history. With an average dividend cover of 1.6, I’m comfortable they all have sufficient earnings to cover payments.
If I had £20,000 to invest in an income portfolio right now, I’d buy all five shares and split my funds equally between them.
As a result, I’d expect to earn at least £1,340 in dividends a year. In addition, companies sometimes distribute special dividends. These are extra payments from excess cash flow. But as these are ad-hoc, I’d treat them as a bonus.
