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I reckon a Stocks and Shares ISA stuffed full of dividend shares is a great way of earning a passive income. But it’s sometimes easy to forget that buying these types of stocks can also be an effective means of generating long-term wealth.
For example, let’s assume there are only two types of investment available – a dividend share that doesn’t grow, and a growth share that doesn’t pay a dividend.
Starting with £20,000 invested (the annual ISA limit), if the former were to pay 5% a year for 25 years, and all of the payouts were reinvested buying more of the stock, the initial lump sum would grow to £67,727. This would be exactly the same result as if the growth share grew at a rate of 5% a year.
Slow and steady
Sometimes it’s easy to overlook the ‘boring’ reliable dividend payer in favour of an exciting ‘sexy’ growth stock.
Continuing with our example of a 5% dividend share, a Stocks and Shares ISA would need to be worth £200,000 to generate passive income of £10,000 a year. With a £20,000 lump sum, it would take 48 years for our investment pot to grow to £208,025.
Although waiting nearly five decades might seem like a long time, I think this is a great result from doing very little. It’s also a perfect illustration of why dividend shares are so popular with many investors.
Of course, it would be possible to get there quicker by investing more up front. Alternatively, investing £2,000 every year for 36 years would create a £200,000+ ISA.
Whatever approach is taken, I think it demonstrates the important role that dividend shares can play in a long-term portfolio.
A sleeping giant
BP (LSE:BP.) is one FTSE 100 stock that currently (6 February) pays a dividend of around 5%. In fact, it’s yielding 5.2%.
The oil and gas giant’s been going through a period of transition. Under pressure from some of its larger shareholders, it’s slowed its investment into clean energy and plans to increase its annual output of hydrocarbons. It’s also seeking to dispose of various assets to help reduce its debt and it wants to improve its bottom line through eliminating thousands of jobs.
The intention is to improve the free cash flow of the group. In theory, this should leave more cash for dividends. When market conditions are in its favour, the group’s previous boss described BP as “literally a cash machine”. However, as the pandemic demonstrated, when energy prices fall, the group’s cash burn is enormous. In fact, it cut its payout in 2020.
But things have calmed down since. The group’s 30% of the way towards restoring the 50% post-Covid dividend cut. And it’s spent billions buying its own shares.
Although I’m conscious that the group’s earnings can be volatile, I think there’s plenty of scope to improve its financial performance and raise its dividend further. That’s why I think it’s a stock to consider.
Fortunately for those who would rather not invest in BP on ethical grounds, there are plenty of other UK shares offering generous yields. And in my opinion, a well-balanced portfolio of them could help generate significant wealth.
