Building a portfolio of dividend shares as a means to earn a second income is a popular method used by British investors. Considering the unusually high yields found on the FTSE 100 and FTSE 250, it’s no surprise many see the benefit in the UK stock market.
Why dividend shares?
Dividend investing can be a reliable source of passive income due to the regular payments. For those wanting to build up an investment, the dividends can also be reinvested to compound the growth. This makes them attractive to both early investors and retirees.
For example, a 5% average dividend yield could generate £500 annually with £10k invested. By reinvesting the dividends, the next payment will increase. Doing this consistently can result in exponential growth.
Maximise returns
The key is to get started as soon as possible, even with just £5 a day. To ensure maximum returns, there’s a few important tips to remember to avoid making common investment mistakes.
Most investors already know the importance of diversification but it’s worth noting. Spreading an investment across different sectors and stocks reduces exposure to a single point of failure.
With dividends, aiming for a high average yield will help maximise returns. But it’s not the only thing to consider. A history of consistent payments is also important — as is the payout ratio. This indicates the company’s ability to cover payments.
Dividends can be cut at any time so it’s important to assess the reliability of payments. A very high yield (10%+) can be a sign of a struggling stock with a plummeting share price.
Two examples
In late 2021, investors may have jumped at the chance to buy Rio Tinto (LSE: RIO) shares after the yield soared past 11%. A growth in profits that year prompted the mining giant to pay a special dividend.
But much of the boost came from the share price having fallen 30% since June, pushing up the yield. By the end of 2022, the payout ratio was over 100% — a worrying sign.
Even though the shares recovered the following year, the company slashed dividends by 38% on weaker revenue and earnings. Further reductions were made the following year, bringing the yield back down to 7.3%.
Lower dividends mean the company can invest more in growth, so things may improve from here. But such a cut still leaves a dent in a high-yield dividend portfolio.
A better option may be Imperial Brands (LSE: IMB). The tobacco giant is a reliable payer with a year-on-year dividend growth rate of 4.5%. Dividends have grown from 43p to 153p per share in the past two decades, with only one reduction during the pandemic.
It has a lower yield at 5.8% but also a lower payout ratio of 50%, so payments are well covered. But while it ticks all the boxes dividend-wise, there is a big risk. Tobacco is facing tough regulations, which could limit sales. If it can’t boost sales of vapes or next-gen products (NGP), profits could take a hit.
Since 2020, NGP revenue is up 64%. Last year alone it grew 26.4%, helped by the launch of Zone oral pouches in the US. If that continues, it could remain a strong dividend stock. For investors focused on reliable dividend returns, I think it’s a stock worth considering.
The post Here’s what to look for when aiming to earn a second income from dividend shares appeared first on The Motley Fool UK.
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Mark Hartley has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands Plc. 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.
