Earning some extra money could often come in very handy. But the prospect of working more hours each week might not sound as appealing. An alternative approach to earning a second income is to invest in shares that pay dividends.
Here is how I would use that approach to build up over time towards a monthly target of £1,000 in dividends.
Dividends as income
Basically, dividends are a way for a company to share some or all of its excess cash with shareholders. So to pay them year after year, a company needs to make profits and not spend them on other things like growth projects.
That will not always happen. Some companies are not profitable and others like Google parent Alphabet keep their spare cash inside the business.
Dividends are never guaranteed, clearly.
But that does not mean they cannot be a great way to build a second income. I simply focus on finding companies I think have the financial capacity and will to pay them far into the future. I also spread my investments, so that all my eggs are not in one basket.
Having a goal
Knowing how much I might earn from a shareholding depends on what I pay for it and the expected dividend income. The annual income as a percentage of my purchase cost is known as the dividend yield.
So for example, a 5% yield means I would hopefully earn £5 each year for every £100 I invested. To hit my target of £12,000 annually would take £240,000 at that yield.
I could achieve my second income goal with less if I achieved a higher yield, but I would not want to do so if it meant investing in lower-quality companies. My primary focus would still be buying into great companies I think had promising profitability prospects.
Step by step
There is no need to invest that money all at once. In fact, I could start today simply by putting spare money aside on a regular basis to invest.
Doing that could take years or decades, but along the way to my target I ought to start earning at least some dividends.
To get going, I would set up a share-dealing account, or Stocks and Shares ISA. That way, I could start putting money aside immediately, ready to invest when I find some suitable ideas.
Finding investment ideas
I would stick to businesses I understand when considering what to buy. Not only would I focus on finding great businesses, I would also pay attention to valuation. The cost I pay influences yield, after all.
On top of that, I am not just focused on the dividend potential. If a share pays me a dividend but falls in price, I could be earning money in one hand and losing it in the other if I decide to sell the shares.
This post was originally published on Motley Fool
