The idea of earning some extra income without working for it can become a reality by owning the right dividend shares.
Some blue-chip shares pay out some or all of their free cash flows to shareholders in the form of dividends. But not all do, even if they have been in the habit of paying before. Their business circumstances or priorities may have changed.
By making a careful selection of a diversified range of blue-chip shares, I reckon I could target a four-figure extra income each year in the future by investing £7,000 today.
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Doing the maths
I am a long-term investor. So, although I would aim for £1,000 in extra income annually, I would expect to wait some years before I started to collect.
£1,000 is 14.3% of £7,000. In other words, to earn that much I would need to earn an average dividend yield of 14.3% on my £7,000.
No FTSE 100 share has such a high yield. But I could aim to achieve that yield over time by investing my money now, then reinvesting the dividends in buying more shares. That is something known as compounding.
If I could earn an average yield of 8% and compounded my returns, then after eight years I ought to be earning over £1,000 in extra income annually, in the form of dividends.
Building a portfolio
Is an 8% average yield achievable?
I think it is, although my search for shares to buy would not begin with yield.
As no dividend is guaranteed to last, a yield is not necessarily indicative of what I might end up earning from a given share.
So I focus my search on looking for great companies with a sustainable competitive advantage, that I think are selling at an attractive valuation. I then consider whether such a firm might be able to generate sufficiently large free cash flows in future to fund a juicy dividend.
A lot of the information I use to do that is available in a company’s annual report and accounts. I also apply my own judgment. That is why, when investing, I stick to businesses I feel I can comfortably understand.
Finding income shares to buy
I would build a portfolio spanning different shares, to diversify it. With £7,000 to invest, I would buy shares in five to 10 different companies.
In terms of the sorts of shares I would happily buy for extra income if I had a spare £7,000 to invest today, Legal & General (LSE: LGEN) is an example that helps illustrate my approach.
With a well-known brand and large customer base in a market likely to benefit from resilient long-term demand, I think the business has the makings of a strong dividend payer. It has been consistently profitable in recent years and currently offers a yield slightly over 8%.
A financial crisis could hurt profits and lead the FTSE 100 firm to cut its dividend, as it did back in 2008.
But, taking a rounded view, I would happily own Legal & General and other blue-chip shares as I aim to build extra income.
