Dividend shares can be an excellent source of passive income. Many companies pay a share of their profits to shareholders in return for investing in their business. These payments come in quarterly cash payments called dividends.
Dividend shares are often mature, established, and grow at a slower pace than growth shares, for instance. That can result in more stable cashflows and reliable dividend payments.
Quality dividend shares
The FTSE 100 is home to dozens of quality dividend shares. Overall, the lead index offers a dividend yield of 3.6%. With rising savings interest rates, it might not sound like much.
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But as it’s an average, it masks some of the highest-yielding stocks. For instance, nine of the 100 shares currently offer over 7% a year. I also frequently see them toward the top of the list.
It’s important to note that the greatest dividend yield doesn’t necessarily mean it’s the best option. There are other factors that investors should consider too.
For instance, in addition to a chunky yield, I like shares that have a long history of regular payments. Consistently paying out dividends over many years offers confidence to an investor.
Long-term prospects
Next, the best shares have dividends that are well-covered by earnings. There’s nothing worse than seeing a company borrow money to fund promised dividends. That’s why I look for a dividend cover ratio of more than 1.5.
Last, but not least. The approach I take to find the best dividend picks considers the long-term prospects of the business. I want my companies to thrive and continue making profits.
Sustainable cash flows are often found in businesses that display strong competitive advantages. It’s a feature that famous investor Warren Buffett calls a moat.
Investing £10,000
Now that I know what I’m looking for, I’d pick a broad selection to buy that covers different industries. That should provide some diversification and prevent me from putting all my eggs in one basket.
If I had £10,000 to invest towards dividend shares right now, I’d buy £2,000 each of Phoenix Group, Taylor Wimpey, British American Tobacco, Legal & General and Rio Tinto.
On average, this selection offers a 7.7% yield. In addition, it provides dividend cover of 1.7 and a 19-year payment history. That sounds appealing to me.
Some thoughts
Currently, all five are high-quality businesses with strong competitive advantages. But as that can change over time, I’d still need to monitor their progress. New technology or competition can often disrupt a company’s business model.
One thing to bear in mind is that share prices can rise and fall. But as I’m focused on earning a second income from dividends, I’d likely ignore these short-term gyrations.
Overall, this selection would give me £770 in additional income. If it doesn’t sound like much, consider what happens if I invest £10,000 every year for a decade.
By reinvesting my dividends instead of withdrawing them, I calculate that I’d build a pot worth £142,818. That’s enough for an £11,000 annual second income.
