One common way to earn some extra income is by investing in shares that can hopefully pay dividends.
I say hopefully as dividends are never guaranteed, even if a business has been a generous payer in the past (Direct Line is an example, having scrapped its shareholder payout this year).
But by carefully looking at the business health and share price valuation of some blue-chip companies I come across in everyday life, I hope I could earn some pretty meaty passive income.
Imagine my target was £500 each month on average. How much would I need to invest?
Calculating possible dividend income
There are two factors that determine how much I might earn in extra income from owning dividend shares: the size of my investment and the average dividend yield I earn on it.
For example, if I invest £100,000 at an average yield of 7%, that should earn me £7,000 annually in dividends. That is already more than my target, as £500 each month adds up to £6,000 in a year.
But yield is not fixed. It depends on the dividends paid out by a company in any given year, which, as explained above, can change for better or for worse.
Setting up a target
Still, dividend cuts rarely come from nowhere. Some businesses like Diageo and investment trusts like City of London have raised their payout annually for many decades already.
By finding high-quality, consistently profitable businesses with strong cash flows and healthy balance sheets, hopefully I can improve the chances that I may not only keep receiving the same dividends, but even see them grow as the years pass.
In any case, I would diversify my portfolio across a range of shares to reduce the overall impact of a dividend cut by any one company in which I invest.
With my target of £6,000 a year in extra income, at a 7% average yield, I would need to invest just under £86,000.
If I could earn a higher yield, that would let me hit my target while investing a smaller amount. I would never just chase yield, though. I always try to stick to high-quality companies I think have what it takes to pump out dividends year after year.
Building up bit by bit
Still, £86,000 is a lot of money. What if I had the same extra income goal – but no spare cash to invest?
I would simply put money regularly into a Stocks and Shares ISA or share-dealing account then compound (reinvest) my dividends.
Doing that with £500 a month at an average yield of 7%, I would hit my target in just over a decade, presuming for the sake of the example, that share prices and dividends are constant.
At that point, instead of putting £500 a month in, I could start taking £500 each month out as extra income!
