When it comes to building a second income by buying dividend shares, several factors can make a massive difference to how much ends up flowing in.
One is how much is invested. For now though, I will largely ignore that and simply assume someone is willing to invest the relatively modest sum of just under £100 a month (specifically, £99).
The two factors I want to zoom in on today are timeline and return on investment.
A long-term approach can have a force multiplier approach
This approach to building a second income depends on investing money over time in shares and initially reinvesting any dividends or sale proceeds (known as compounding).
Only later is the portfolio used to generate passive income in the form of dividends.
How much later? That is a matter of personal choice for the investor – but makes a big difference. Imagine that £99 a month is invested and compounded at 10% annually for different periods of time.
The portfolio value at the end of the period changes significantly.
| Number of years | Portfolio value at end of period |
| 10 | £19,801 |
| 20 | £71,161 |
| 30 | £204,376 |
| 40 | £549,900 |
Just a few percentage points can have a huge positive impact
Ten percent is an ambitious compound annual gain target. Why have I used it? Partly to illustrate how performing just a little bit better can transform results.
In the above table, if I had used 8% instead of 10% as the compound annual gain, would the portfolio value after 40 years be 80% of £549,900?
Nowhere near! In fact, it would have been just 58% of that amount, at £319,044. Still a great result, yes – but far lower than with the 10% number.
By the way, 10% is also a very ambitious target yield when the time comes to generate second income. As that is decades into the future and yields can move up and down, here I will just focus on the compound annual gain aspect of the approach.
Looking for the rare massive outperformers
In any diversified portfolio there will likely be some disappointments. To hit a 10% compound annual gain over a 40-year timespan requires some real outliers in terms of performance.
But such shares exist. As an example, at 51 times earnings, the Diploma (LSE: DPLM) share price looks costly. But it has soared 144% over five years and 768% over 10 years.
The business, which provides critical, low-cost components to essential industries, has a proven model with attractive profit margins. The operating margin has grown to 24.5% and management reckons it can go higher.
Sales are strong and I see lots of scope for ongoing growth. Organic sales growth in the first half was a very healthy 15% year-on-year.
As I see it, what has driven a lot of the growth in Diploma’s share price – and I think may potentially keep doing so – is its strategic focus on business areas that offer pricing power and can generate strong cash flows.
The dividend yield of 0.9% is small but could grow if the business keeps doing well.
One risk is that the company’s seals business outside North America is struggling amid soft market conditions. That may continue.
For now, Diploma shares are too pricey for me. But I am keeping close watch in case the valuation becomes more attractive.
Should you invest £5,000 in Diploma Plc right now?
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Christopher Ruane does not hold any positions in the companies mentioned.
