A lot of people want to earn some extra income to supplement their regular earnings. But setting up additional income streams can often be time-consuming.
One reason I like investing in dividend shares is that they can help me earn extra money without adding to my time commitments. I simply buy the shares, hold them, and hopefully collect dividends.
Here is how I would use that approach if I wanted to target £500 each month in dividends.
What are dividends and how do I get them?
When a company makes profits it has a choice of what to do with them. Sometimes it will keep them in the business to help fund growth. That is why even some very profitable companies such as Google owner Alphabet do not pay a dividend.
Alternatively, a company may pay out some, or all, of its profits as dividends. Take Shell as an example. Last year, the oil giant reported around $20.1bn in profits (after setting aside some minority interests). It paid out $6.3bn in dividends to shareholders. So if I had owned Shell shares during that time, I would automatically have received some of that money. Exactly how much would depend on how many shares I held.
Receiving extra income in the form of dividends really is that simple – I can buy shares and receive the payouts. However, it is also important to realise that dividends are never guaranteed. Even a company that has paid out in the past can cancel, or reduce, its dividend as Shell did in 2020.
Finding dividend shares to buy
So how could I find shares that seem likely to maintain or raise their annual dividend? As dividends are never guaranteed, there is no way of being sure. Indeed, that uncertainty is one reason I always keep my portfolio diversified across a range of shares.
But I also try to choose shares I think look like they may be able to pay big dividends in future. As well as profit, I also consider their potential for free cash flow. While profits are an accounting measure, free cash flow is a measure of the hard cash that comes in (or goes out) of the door. Obviously that is important. Without surplus cash, it is difficult to keep paying dividends.
So I look at whether a business has some sort of competitive advantage that could help it continue to generate cash in future. For example, it may have a unique distribution network like National Grid or an iconic brand like Nike.
Targeting extra income
How could I plan to try and hit my target of £500 in extra income each month? The amount I might earn from my portfolio depends on the average dividend yield of the shares I buy. A 5% yield, for example, means I will hopefully earn £5 per year for every £100 I spend on the shares.
At that rate, to try and generate £500 per month in dividends, I would need to invest £120,000 in shares. But if I had less money to spare, I could try building up to my target level of extra income over time.
Either way, I would not just chase yield but always focus on finding what I see as quality companies with good prospects.