The FTSE 100 is home to many high-quality dividend shares. That’s where I’d look if I was targeting a second income.
Companies that offer dividends to shareholders are essentially sharing a portion of their profits in return for my investment.
The amount that each company distributes varies. To aid growth, some businesses choose to reinvest profits instead. But many FTSE 100 companies opt to pay a dividend.
I calculate that almost 90% of FTSE 100 shares are currently paying a dividend. And the average dividend yield is 4.2% right now.
That means if I invest £5,000 in the FTSE 100 index, I should receive around £210 a year in passive income.
But I reckon I could earn a lot more by carefully picking and choosing a smaller selection of shares.
Stable shares
For instance, several Footsie shares currently offer more than 6% a year. Although the dividend yield is an important factor, I’d also look for several characteristics for the best shares.
For a reliable second income, I’d want to own shares that have consistent earnings. That should result in a steady stream of dividends as they tend to be paid from current earnings.
To find this characteristic, I’d look for stable and mature businesses. I’d also look at a company’s dividend history. A business that has distributed dividends for several decades gives me some confidence that it could continue to do so.
Bear in mind that things can change, so I’d still need to monitor my preferred shares. New competitors or technologies could affect a company’s outlook.
Affordable dividends
Next, I’d want to own shares that can comfortably afford their dividends. To find these, I’d look for businesses that are unlikely to see a sharp downturn in earnings any time soon.
Right now, with the UK heading towards a recession, I’d avoid cyclical shares. Instead, I’d focus on owning more consumer staples and utility companies.
In addition, I prefer shares that have dividend cover greater than 1.2. Dividend cover shows how well a company’s payout is covered by its earnings. A figure below one would indicate that its current earnings might not be enough to pay for its dividend.
Five top stocks
If I had an extra £5,000 to put towards building a second income, I’d split it equally between five selected FTSE 100 shares. Some of those that meet my criteria right now include Imperial Brands, Unilever, Vodafone, National Grid and SSE.
With this group, I’d be getting a 6% yield, dividend cover of 1.6, and an average history of 29 years.
That’s enough to earn £300 a year in passive income. It might not sound like a lot right now, but over time I could add to my pot and continue to buy more of these dividend shares.
If I’m able to invest £5,000 every year for the next decade, I’d build a pot worth around £66,000. That’s enough to earn almost £4,000 a year in dividends thereafter.