Image source: Getty Images
Thinking of stuffing an ISA with dividend shares as a way to earn passive income? That is exactly what lots of people do – and it can be a lucrative approach to generating some additional income without having to take an extra job.
Here’s how dividend shares work
To start, let me explain a bit about why dividend shares can potentially be lucrative. When a company generates spare cash, it typically has a choice of what to do with it. It might plough it back into marketing, for example, or invest in research and development.
Some firms decide to use a part or all of their spare money to pay dividends to shareholders. Simply by owning such a share could earn dividends.
But a couple of things are important to note. Dividends are never guaranteed, even when a company has paid them in the past. Also, share prices can move around, for better or worse – so the total financial return is not just driven by dividends, share price also matters.
Targeting a £1,000+ monthly second income
When assessing what might be earned from a dividend share, we look at its prospective dividend yield. That is the expected annual payout per share, expressed as a percentage of the purchase price.
The FTSE 100 yields 3.3% at the moment. In today’s market, I think it is possible to target a higher yield while sticking to proven blue-chip businesses. In this example, I will use 6%.
Earning £1,000 a month on average means an investor will need to generate over £12k annually in dividends, or more. At a 6% yield, that will require a £200k sum in the ISA.
That is more than the usual annual ISA contribution allowance. So that is where the idea of drip-feeding money in can be helpful. If someone puts £20k a year into their ISA and builds a portfolio of dividend shares that compounds in value at 6% annually, it ought to be worth over £200k after nine years. Invested at a 6% yield, that is enough to earn over £1k a month on average in passive income.
Choosing the right ISA helps
Clearly a key part of this approach is choosing the right shares. But total return can be eaten into by commissions, dealing fees and other charges. So choosing a suitable Stocks and Shares ISA is important too.
Finding shares to buy
One dividend share I think investors should consider is British American Tobacco (LSE: BATS). Its dividend yield of 6.1% is above the 6% target I mentioned above. The FTSE 100 cigarette maker also has a decades-long history of raising its dividend per share annually. It aims to keep doing so.
However, sales volumes are in long-term structural decline in many markets. Non-cigarette products have yet to prove anything like as profitable. That is a risk to British American’s cash flows.
But cigarette sales, while falling, remain substantial – and massively cash generative. British American owns a stable of premium brands that give it pricing power. It is also expanding more and more into non-cigarette products such as vapes.
