When it comes to earning a second income, one very old idea is also still a popular and potentially very lucrative one.
That idea is buying shares in proven businesses that look likely to pay out dividends to shareholders in future.
Just how lucrative might such an idea be? Let’s find out!
Turning a Stocks and Shares ISA into an income machine!
Part of the answer depends on how much is invested. In this example I will presume that someone uses £20k in a Stocks and Shares ISA. Less (or more) would work, with correspondingly different results.
Another factor is the average dividend yield that the ISA earns.
Currently, the FTSE 100 yields 3% while the FTSE 250 offers 3.5%. But a higher yield should still be possible even while sticking to high-quality businesses, I reckon.
A 5% yield on £20k could produce £1k per year in second income, for example.
Another factor to consider is the timeline. Dividends are never guaranteed. That £1k per year could decline in future.
But it could also stay the same — or rise. Indeed, if someone carefully chooses the right shares to own for their ISA, hopefully the dividend income will rise over time.
Time can matter in another way. Instead of taking dividends out as cash from the beginning, an investor may choose to reinvest (compound) them.
For example, doing that for a decade at 5% annually (and ignoring any share price movement for the purpose of this illustration), the ISA should grow to be worth over £32k. At a 5% yield, that would mean an annual second income of £1,600.
On the hunt for income shares with dividend growth potential
Clearly a key part of this approach lies in identifying multiple high-quality dividend shares that have long-term potential and sell for an attractive price.
One dividend share that I think merits investors’ consideration is FTSE 100 insurer Aviva (LSE: AV).
Its dividend cut in 2020 illustrates the point I made above, that dividends are never guaranteed.
Since then, though, the dividend has been growing generously. At the moment, Aviva yields 5.9% — well above the 5% target I used as an example above.
I also think Aviva has a healthier business now than it did a few years ago. A 67% growth in its share price over the past five years suggests that the stock market sees things that way too.
With its strong domestic focus and market-leading position in the UK, Aviva has economies of scale and benefits from a large customer base.
It has slimmed down its overseas operations in recent years while seeking to become even stronger domestically, for example, through its acquisition of Direct Line. That has given it a sharp, powerful strategic focus I think bodes well for its ongoing cash generation potential.
That market leadership does expose it to risks, though.
Smaller rivals may try to grow their business by competing on price. As the market leader, that would be an expensive game for Aviva to participate in, but if it did not, it could lose customers.
From a long-term perspective, however, I like the business – and its income prospects.
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Christopher Ruane does not hold any positions in the companies mentioned.
