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.
The post A second income for £10 a day? Here’s how! appeared first on The Motley Fool UK.
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C Ruane has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended Apple, British American Tobacco P.l.c., and Vodafone Group Public. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.