Dividend shares are an excellent source of passive income, in my opinion. But there is much to consider. With thousands of available shares, which shares should I buy?
To answer that, I’d first outline my goal. I want to get to a stage where I’m earning income without having to work for it. Let’s say my aim is to earn an extra £5,000 of passive income every year for life.
The average FTSE 100 yield is around 4%. If I only invested in this large-cap index, I’d need a pot of £125,000 to reach my goal.
But it’s possible to achieve much more with a lower investment by buying a basket of high-yielding dividend shares. Consider that some shares currently yield as much as 13%.
More isn’t always better
Bear in mind that significantly large dividends might not be sustainable. If the outlook changes or if earnings fall, companies can cut or suspend dividend payments. That can lead to not only a drop in the dividend yield but also a sharp decline in share price.
That’s why I’d much rather own reliable dividend shares, even if they don’t currently pay the most. For me, the most optimum yields are around 5%-8%. These shares pay above-average dividends, but tend to be more sustainable than some of the highest yielders.
Finding the best dividend shares
Let’s look at which shares I’d pick right now. But first and more importantly, let’s consider how I’d find them.
To find a reliable and sustainable dividend share, I’d look at its history. Although the past doesn’t predict the future, it can give a clue to how a company treats dividends.
For instance, a company that has a policy of consistently paying cash to shareholders for many years could be more reliable than one that frequently stops and starts pay-outs.
Next, I’d look at its dividend cover. This is a measure of how many times a company can pay its dividend from its earnings. The greater this number, the more comfortable I’d be that it can afford to pay. I’d look for a cover of at least one but closer to two is even better.
Then, I’d consider the business prospects. If I think a companies’ earnings can grow, then there is a good chance that its dividends could grow in the future too.
Shares to buy right now
Shares that meet my criteria right now include Phoenix Group, Imperial Brands, Legal and General, Royal Mail, and Vodafone.
These dividend shares operate in a variety of industries. That allows me to diversify and spread my risk. If one sector experiences a decline, other industries might not be affected.
I’d note that on average, my selection yields 7% and has a dividend cover of 1.6. They’ve also been paying dividends to shareholders for over 20 years, on average.
I’m confident that by owning these five shares, I’d be getting a reliable, consistent, and above-average dividend yield.
At 7%, to earn £5,000 in dividends, I calculate that I’d need a pot of over £70,000. It might sound like a lot now, but my making regular investments over several years, I reckon it’s a realistic goal.