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With the expenses that can pile up this time of year, the always appealing idea of a second income may seem even more appealing than usual.
However, earning a second income doesn't necessarily mean having a second job.
A common way for people to earn some extra money without working is by investing in stocks that pay dividends.
Understand the Basics of Dividend stocks
Not all stocks pay dividends. Even when one does it, it can stop at any time. For example, card factory announced this week that its trading cost base has been widely affected in the wake of the Budget and it plans to cut its dividend.
That's why when I buy income stocks, I try to find those that I think can maintain or increase their dividends, but I spread my options among several companies, since the unexpected can always happen.
The amount I earn in second income depends on the average dividend yield I get from a stock.
If I invest £1,000 in shares yielding 5%, for example, I expect to earn £50 a year in dividends (although, as I explained above, that could end up being less or more).
Find stocks to buy
But simply observing performance can be a piece of cake. It is important to understand how likely a company is to be able to fund a given level of dividends in the future and whether the dividend payout is in line with the company's strategy.
After all, excess cash can be used in other ways, from investing for growth to building cash reserves or buying back stock.
That's why I look for companies with a large addressable market, competitive advantages and the prospect of generating significant free cash flows with which to finance dividends.
A High Yield Stock I Own
As an example, I would point to a stock in my own portfolio: M&G (LSE: MNG).
He FTSE 100 The asset manager operates in a global industry that is huge and will likely remain so for the foreseeable future. Thanks to its well-known brand, its large customer base spread across various markets and its deep experience in the financial markets, I believe that M&G has a competitive advantage.
It has proven capable of generating significant free cash flows and that has supported a generous dividend that has been growing in recent years. Currently, M&G's dividend yield is a juicy 10.1%.
Can that last?
One concern I have is the risk that economic volatility and weak growth prospects could lead investors to withdraw funds. M&G clients (outside its Heritage division) took out more money than they put into their funds in the first half.
However, for now I have no plans to sell my shares.
Generate large dividend flows
That 10.1% return is much higher than the FTSE 100 average of 3.6%.
But even achieving a more modest average return (say 6%), I think a long-term investor could aim for a second annual income of £10,000.
Investing £180 per month and compounding at 6% per year, the portfolio should be worth more than £168,000 after 29 years. At a 6% yield, that would generate more than £10,000 a year in dividends.
An investor could start generating the second income sooner by going from compounding to receiving cash dividends, but the amount would be smaller.
