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The prospect of earning some extra money on the side does not to have involve taking on another job. In fact, some people generate a second income while they sleep thanks to owning shares that pay them dividends.
As a passive income idea, I like that for its genuinely low amount of effort. I also appreciate that it can be tailored to each person’s individual financial circumstances.
For example, if someone had a spare £500 and wanted to set up a second income in the coming month, here is how they could go about it.
Getting ready to invest
A practical first move would be to set up an account that enables them to buy dividend shares. That could be a share-dealing account, Stocks and Shares ISA or trading app.
Before putting any money into the market, it is wise to get to grips with some key concepts about how it works, such as valuing shares and diversifying a portfolio. Even £500 is sufficient to do that, by spreading it across different shares.
Looking for income streams
It is also worth spending some time learning how dividends are funded.
They are not guaranteed and some companies abruptly stop paying them. Other companies tend to go through cycles, with a chunky dividend for years followed by little or nothing for a few years then more big dividends again. That could reflect the cyclical nature of a business like mining, for example.
Some companies pay out more than the spare cash they generate, which can only be sustained for so long before the dividend needs to be cut. Others pay out far less, meaning that they can keep raising the dividend for years if they choose to, even though profits are flat.
Ultimately dividends require free cash flow. So when looking for shares that might boost my second income, I always try to consider what a company’s cash flows might look like in years (and even decades) to come.
One share to consider
As an example, consider British American Tobacco (LSE: BATS).
It has raised its dividend per share annually for decades. It owns premium brands and has a large distribution network, meaning it can generate large free cash flows in the lucrative cigarette business. Between last year and 2030, for example, the FTSE 100 company expects to generate a staggering £50bn of free cash flows.
That could enable it to keep growing the dividend, which it spent £5.2bn on last year alone.
But will the free cash flows continue to be as strong? With £37bn of borrowings (including lease liabilities), British American has a less attractive balance sheet than I would like.
On top of that, ongoing decline in cigarette smoking rates could hurt future cash flows. Non-cigarette alternatives could help mitigate that, though.
Earning income without working for it
On balance, I see British American Tobacco as a dividend share investors should consider.
Its dividend yield of 6.9% is well above the FTSE 100 average. But if an investor was to target a 6% yield, for example, that would mean that for every £100 they invest today they would hopefully earn £6 in second income annually.
So £500 invested in July could set up a yearly £30 income stream. That is just the start, if more money is invested later.
