Many of us invest to earn a second income. Some of us are looking to take that second income now, and others are willing to reinvest it to build wealth and draw down at a future date. I’m interested in having another source of income in the future.
To generate a second income worth £2,000 a month, I’d need to have a sizeable investment in dividend stocks. How could we make this happen then? Let’s take a closer look.
My starting point
Apparently, the average buyer needs a £62,500 deposit to get onto the housing ladder. So, I’m going to use this £62,500 as my starting point. Let’s imagine I have £62,500, but I don’t buy a house. Instead, I decide it’s a better idea to keep on renting, or maybe I can find myself a 100% no-deposit mortgage, and so I invest that money.
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Compounding
For me, 8% is roughly the best dividend yield that can be achieved on the FTSE 100 without sacrificing the sustainability of the dividend. If I had £62,500 invested in stocks paying an 8% yield, I’d only receive £5,000 a year.
So, I’m going to need to grow my £62,500. And I’m going to do that by using a compound returns strategy — the process of reinvesting my returns.
When considering total returns, I can realistically look to achieve 10% a year. So, if I reinvested for my £62,500, while contributing £250 a month, while increasing this contribution by 5% a year, after 12 years, I’d have £300,000.
Which stocks?
Now, for part two.
With £300,000, I can invest in higher yielding dividend stocks. With £300k invested in stocks with an average 8% dividend yield, I would hope to receive £24,000 a year, or £2,000 a month.
Well, for the compound returns phase I want dividend stocks that can continue to generate share price growth over a long period of time. My top pick for this is Lloyds.
The UK banking stock currently offers a 5.1% dividend yield, but should rise to around 6.5% in 2024 at current prices when taking into account forecast dividend increases.
I’m also expecting the share price to continue rising over the next decade. Discounted cash flow analysis suggests that the stock could be undervalued by as much as 60%.
In fact, I’d suggest that banks are a great place for me to start for dividends and share price growth. I’m concerned about near-term impairment charges on bad debt, but in the medium term, I think this is a great place to be.
But when I want to draw down and take my £2,000 a month (part 3), I’m going to need to focus on companies with higher yields. At this moment, these stocks include Legal & General, Phoenix Group, and M&G. All these currently offer dividend yields above 8%.
The catch is, they don’t offer much in the way of share price growth. And, of course, it’s worth remembering that dividends can always be cut or cancelled. As such, I will need to assess the sustainability of the dividends.
