Ever thought about whether you could earn a second income on the back of other people’s work not your own? That is basically the appeal of having a portfolio of blue-chip dividend shares.
Invest money now, reap the rewards later
To illustrate how that might work in practice, imagine someone has a spare £9,000 today. They put that into a share-dealing platform (like a Stocks and Shares ISA or share-dealing account) and then compound it at 7% annually.
That means they do not need to pay in another penny, but any dividends received are reinvested. Share price growth could help boost the value, although falling share prices could eat into it.
At that 7% compound annual growth rate, after 20 years the portfolio ought to have almost quadrupled in value to around £34,800. At a 7% dividend yield, that could mean an annual second income of roughly £2,438.
Not rocket science, but good practice can help
In today’s market, I think that 7% target is achievable when sticking to well-known, blue-chip companies with proven business models.
I do think some principles of good investing can help improve the chances of success though, from diversifying across multiple shares to taking a long-term approach to investing.
Sticking to what you understand sounds obvious, yet not all investors do it, moving closer to speculation than investing.
What makes an attractive dividend share?
When investing to try and build a second income, I like to stick to what I know, but that does not mean just looking at the world as it is now.
Dividends are never guaranteed, so it is important to consider what a company’s future dividend prospects are, not just its current or past payout. To assess that, I try to judge what I think its free cash flows will be over time.
For example, Rolls-Royce may well increase its free cash flows in coming years as it continues to deliver on its business goals. Then again, the Middle Eastern conflict could hurt demand in its civil aviation division. Either way, even if free cash flows do grow and the dividend follows, the current yield is only 0.7%. From an income perspective I do not find the share attractive.
Going up in smoke, or will the cash keep flowing?
By contrast, a different FTSE 100 share I think merits consideration at the moment by investors with an eye on a second income is British American Tobacco (LSE: BATS). The yield here is a much juicier 5.6%. British American Tobacco has also grown its dividend annually for decades, and aims to keep doing so.
One risk that could prevent that is the decline in cigarette smoking. Sales volumes, after all, are falling. But the firm’s premium brand portfolio allows it to mitigate that to some extent by raising prices. But even so, revenues are in decline.
But while the sales trend is negative, tobacco remains big business. British American remains highly cash generative. I expect that to remain the case for many years.
Not all investors are willing to own tobacco shares for ethical reasons. For those who are and are on the hunt for some extra passive income, I see this as one to consider.
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Christopher Ruane does not hold any positions in the companies mentioned.
