Buying dividend shares to earn extra income is a strategy employed by millions of investors. One common income share with UK investors is tobacco manufacturer Imperial Brands (LSE: IMB). With the Imperial Brands dividend yield currently sitting at 7.8%, owning the share could turn out to be a lucrative passive income idea over the long term.
On paper, I think I might be able to target £742 of dividends by putting £1,000 into Imperial shares today.
Should I?
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Doing the arithmetic
First let me explain how I reach that figure.
If I invest £1,000 in the shares today and keep reinvesting the dividends (something known as compounding), then after 30 years I ought to own £9,518 worth of shares in the company.
At that point, I would be receiving £742 in dividends annually and could keep compounding, or take them out as cash.
Unpicking the assumptions
There are several assumptions in that sum.
One is that the share price and dividend remain the same over time. In practice that is unlikely. The shares are down 24% over the past five years.
They could keep falling if declining cigarette revenues hurt profits badly. Then again, value investors might turn more favourable on the company and push up its share price.
The dividend has been growing in the past couple of years. Last year saw 4% growth. However, the recent trend comes on top of a swingeing cut in 2020.
The power of long-term investing
As an investor I think a long-term approach makes sense.
I believe the Imperial Brands dividend illustrates why.
In the short-term, the juicy payout looks attractive. Tobacco is a highly cash generative business and that can help Imperial fund its dividend. Last year alone, Imperial generated £2.3bn of free cash flow.
But what about the long term?
Tobacco is a market where per capita demand is in structural decline. Population growth in some emerging markets may help offset that, but the long-term picture for cigarettes will likely see their consumption shrinking. Indeed, Imperial’s rival British American Tobacco (LSE: BATS) wrote down the long-term value of some of its key cigarette brands to zero.
That is an industry-wide problem. But while firms like British American are pushing aggressively into cigarette alternatives, Imperial has moderated its ambitions in that corner.
For now its main strategic focus is building market share in key cigarette markets. In the short term that could help the cash keep flowing. Long term, though, it looks like strategy that will see diminishing returns.
Other cigarette shares are also available
That is relevant from an income perspective, as ultimately maintaining let alone raising the Imperial Brands dividend requires the right level of free cash flows.
If I wanted to target sizeable dividend income by investing in a tobacco share, Imperial would not be my choice.
I would rather choose one like British American (which I own) that faces similar challenges but has what I see as a stronger strategy to deal with them.
On top of that, its current yield is 9.7%. So investing £1,000 today and compounding it, using the same assumptions as in my Imperial example above, should let me hit my target in just 22 years, instead of 30.
