Dividend shares can be a great way to earn a passive income. Once I’ve made my investment, I can just watch the cash roll in without much additional work from me.
Not all companies pay dividends to shareholders though. Some choose to reinvest profits to try to grow the business instead. That’s why many dividend-paying companies tend to be established and more mature operations.
Highest-yielding dividend shares
In the FTSE 100, the five highest-yielding dividend shares are Persimmon, Rio Tinto, abrdn, Antofagasta and M&G. On average, they currently offer a 12% dividend yield.
If I used my £10,000 investment to buy these five shares, I’d expect to receive £1,200 over the coming year in dividends. That sounds great at first glance.
But shares that offer particularly large yields can sometimes be dividend traps. These might display attractive yields now but could disappoint in the future.
For instance, either its dividend could be cut, or its share price could tumble. Either of which would be a disappointing outcome.
Reliable dividend shares
I’d much rather earn a reliable second income. That’s why I’d consider other factors in addition to yield. I’m keen to invest in businesses that are likely to grow over time.
As many will be mature companies, I’d even be willing to accept tepid growth. But I’d avoid investing in industries that face long-term decline.
I’d look for companies that could offer steady earnings growth and those that benefit from pricing power. This attribute is particularly apt in the current inflationary environment.
As costs rise, I’d prefer businesses that can successfully pass these on to customers in the form of higher prices.
The best dividend shares can afford to pay out cash from their current earnings. This is commonly measured by its dividend cover. Any result less than one (meaning earnings are equal to the dividend payout) could indicate red flags with regards to affordability. I tend to avoid these.
Which dividend shares?
So what would I buy? First, I’d consider metals and mining giant Rio Tinto. Best known for producing iron ore, this FTSE 100-listed behemoth should benefit from the global shift towards electric vehicles. Iron ore is used to make steel, and steel is a popular material for EV manufacturers due to its lower cost vs aluminium.
Rio currently has a 12% dividend yield, making it the second largest in the FTSE 100.
Bear in mind that if the global economy slows over the coming year, there’s a chance of a dividend cut. Even so, it would still provide a juicy dividend.
Next, I’d buy Legal & General Group. It’s currently on a 7% dividend yield. What I like about this share is its 30-year dividend history, which suggests a long-standing policy of paying cash to shareholders.
I’m also impressed with dividend cover of 1.7. I reckon it should comfortably be able to afford to continue current levels of payouts. A sharp economic downturn could put earnings at risk, but L&G should benefit from rising interest rates.
Other shares that meet my criteria and that I’d buy include Phoenix Group, Taylor Wimpey and National Grid. By splitting my £10,000 across these five dividend shares, I should be able to earn £800 in passive income. That’s a dividend yield of 8%.