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Owning dividend shares can be a simple and lucrative way to earn a second income. Some people dream of such income — but do not actually start investing in the stock market.
If an investor had a spare £3k and wanted to start investing with the objective of earning passive income, here is how they might go about it.
Setting up a share-dealing account
The first step is a simple administrative one: having a way to buy dividend shares. There are lots of options, with a wide range of share-dealing accounts and Stocks and Shares ISAs available.
Understanding the basics of income investing
Some shares regularly pay dividends to shareholders simply for owning them. But not all shares do – even if they have in the past. On top of that, some shares may pay dividends but fall in value so much that owning them for a period of time can be loss-making overall, not profitable.
So before plunging into the market, it makes sense to get to grips with some important concepts like how to value shares, how to judge whether a company looks likely to keep paying a dividend and how to manage risk. £3k is a big enough sum to diversify a portfolio across a few dividend shares.
There are some great dividend shares out there
While not all shares pay dividends, some do – and in a big way.
When choosing dividend shares for my portfolio, I consider whether a company’s business model means I reckon it looks likely to generate enough free cash flow to pay out chunky dividends in future.
For example, one share I think investors looking for passive income should consider is British American Tobacco (LSE: BATS).
The FTSE 100 firm makes and sells cigarettes and other tobacco products. That is a very lucrative market, thanks to high profit margins, a captive audience, and British American’s portfolio of premium brands.
Large free cash flows enable the company to pay a dividend each quarter. The annual payout has risen each year this century.
Whether it will last remains to be seen. Cigarette sales volumes are still substantial but they are declining in key markets almost every year. It is yet to be proven whether British American’s range of non-cigarette products can take up the slack when it comes to smaller cigarette revenues.
Monthly income now, or in future
Some other FTSE 100 shares also pay dividends quarterly. Some pay less frequently. With the right selection, it should be possible for an investor to earn some passive income each month.
British American yields 7.5%. That means that each £100 invested will hopefully generate £7.50 in dividends annually.
That 7.5% is well above the average FTSE 100 yield, but in today’s market I reckon a 7% yield is achievable while sticking to blue-chip shares.
If someone starts investing today with £3k at a 7% yield, that would mean over £200 of passive income each year.
Alternatively, they could initially reinvest (compound) the dividends to target larger passive income streams further down the line.
