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Without working more hours, what are the possible ways to earn a second income?
One is to put some money into shares that will hopefully pay dividends. This can be lucrative, especially for someone with the patience to adopt a long-term approach to investing.
For example, if someone had a spare £20k available to invest in dividend shares, here is how they could target an average monthly second income of £672.
Taking the long view
A key element here is letting dividends fund more share purchases that in turn can hopefully pay more dividends.
This is a simple but potentially very powerful financial move called compounding.
To show how this works, imagine that the £20k is compounded at an annual rate of 7.5% for 25 years. At the end of that period, without contributing any new money, the portfolio ought to be worth almost £122k thanks purely to compounding.
At a 7.5% dividend yield, that should generate around £672 a month by way of a second income.
Keeping a lid on costs
That compound annual growth rate can come from dividends, rising share prices or both. But it is important to remember that, just as dividends are never guaranteed, share prices can move down as well as up.
One factor that can eat into returns is the costs you pay to buy, sell or even just hold shares.
So, it makes sense to shop around when it comes to choosing a share-dealing account, Stocks and Shares ISA or trading app.
Aiming for strong performance
Is a 7.5% compound annual growth rate achievable? After all, the FTSE 100 yield right now is only 2.9%.
With careful selection of a diversified portfolio of dividend shares, I think it can be a realistic goal.
As an example, one share I think investors should consider is paper manufacturer Mondi (LSE:MNDI) with its 6.4% yield. Although Mondi is in the elite FTSE 100 index, it is a share that many small investors may not be familiar with. As an industrial supplier, it is not a consumer-facing brand.
However, Mondi is in fact a large multinational company. Its operating footprint in multiple markets worldwide gives it breadth and its range of packaging and paper products gives its depth.
Despite all that though, the share price has more than halved over the past five years.
That has been good in that it has pushed up the dividend yield. But it hardly seems like a ringing endorsement of the business. What’s going on?
Put simply, after high demand during the pandemic, a global mismatch between demand and supply has pushed packaging prices down, hurting profit margins in the industry.
That is an ongoing risk for Mondi. Although at the half-year point, its dividend cost was comfortably covered by operating cash flows, other costs meant that the six-month period saw free cash outflows overall. If that state of affairs continues, the dividend could be cut.
However, with a proven and sizeable business, I am optimistic Mondi can plough on and hopefully benefit from a recovery in packaging prices at some point. That could push up the share price, as well as help fund the dividend at its current or even a higher level.
