Is it necessary to work more hours in order to earn more money? Not always. When it comes to building a second income, my own preferred approach is to build a portfolio of dividend shares.
Doing that does not require a big upfront sum and could hopefully pay me rewards for the rest of my life. Here’s how.
How dividends work
When a listed company makes money it has a choice of what to do with it. It may reinvest it in the business, or use it to pay down debt. But it can also make a payment to investors who own its shares.
This is known as a dividend. Dividends are never guaranteed, but some businesses like Spirax-Sarco and British American Tobacco have paid them out to shareholders year after year for decades on end.
Choosing dividend shares to buy
But just because a company has paid out dividends in the past does not mean it will do so in future. So when buying dividend shares, I look at three areas in particular.
First, does the business seem likely to throw off a large amount of surplus cash in future? To do that, a company typically needs to have some competitive advantage that gives it pricing power in a market with lots of customers. Examples are firms like Apple and National Grid.
Secondly, does the business have a healthy balance sheet, or is there a lot of debt?
Too much debt can mean even a highly profitable company reduces its dividend as it needs to pay interest and repay debt. Owning such a share might not help me achieve my objective of building a second income.
Vodafone made a dividend cut for that reason a few years ago. My concern about its groaning balance sheet is why I sold my Vodafone shares this year.
Thirdly, how attractively priced is the share? That affects whether I am getting good value when buying a share. Even a great business can make a bad investment if I pay too much.
Valuation also affects the dividend yield I can expect to earn from a share. Yield is my expected annual dividends as a percentage of my purchase cost.
Building that income
Putting aside £10 a day in a share-dealing account, or Stocks and Shares ISA would give me £3,650 a year to invest. To help manage my risk, I would spread my investment across a diversified range of shares.
In the beginning, this approach would earn me something closer to pocket money than a sizeable second income.
Putting £3,650 into shares with an average dividend yield of 5%, for example, should earn me just over £180 in annual dividends. Over time though, hopefully that could grow.
I could earn dividends from shares for years or even decades after buying them, while using ongoing regular saving to keep purchasing new ones.
That could lead me to a lifelong second income, all for £10 a day.
