How to target a growing second income by investing in dividend shares

Dividend shares can put real cash in an investor’s pocket – no unrealised paper gains, no hoping the stock market goes up. That makes them incredibly attractive for a certain type of investor.

When it comes to trying to build passive income streams, dividend stocks are my number-one asset class. And in the best cases, there’s scope to reinvest for even higher returns in future.

Compound interest

If you can find a stock with a 7% dividend yield and reinvest the cash you get from the business to buy more shares, you’ll compound your returns at 7% each year. And that can be powerful.

It’s roughly enough to double the value of an investment (and the annual return it generates) every 10 years. So something that yields £1,000 a year returns £4,000 a year after 20 years.

There is, of course, an important catch to this. Reinvesting the cash you receive to buy more shares means you can’t use it for other things – like holidays or living expenses.

Investors often overlook this point, but it’s crucial to manage working returns properly. If the company doesn’t increase its dividend, generating growth involves giving up the current returns.

Growing businesses

This means the key question for investors looking for a growing dividend is whether a company can increase the amount it returns to shareholders. And that comes down to one thing. Over the long term, businesses can only return more cash to shareholders if they’re bringing more money in themselves. Specifically, if their net income is going up.

In the short term, there are things firms can do to keep paying (or even growing) dividends when earnings falter. But this can’t go on indefinitely – sooner or later the business has to catch up.

That means investors targeting a second income that grows without reinvesting today’s returns have to find firms that can make more money. And the UK has some interesting candidates.

An established success story

Croda International (LSE:CRDA) is a stock that arguably encapsulates all of this. The dividend yield is currently 4%, which is unusually high compared to the last 10 years.

It’s a specialty chemicals business and cyclical end markets bring a risk of demand falling. Despite this, the firm has increased its dividend per share annually for more than 30 years.

Things have been tricky lately though, and the company’s dividend isn’t currently covered by its earnings as a result. If this doesn’t change soon, that impressive record could be in danger.

Croda however, has been shifting its product lineup to focus on markets that are less cyclical. And if it can reduce the cyclical risk, there could be a lot to like from an investment perspective.

Income investing

The best businesses for income investors are ones that can increase their dividends each year. That means shareholders get more cash without having to use their returns to generate it.

Croda International has an outstanding record in this regard. But the business has been under pressure recently with unusually weak demand in certain markets. 

The time to look at buying this type of stock though, is when things look tough. So I think income investors should pay close attention when the company issues its next update in February.

The post How to target a growing second income by investing in dividend shares appeared first on The Motley Fool UK.

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Stephen Wright has no position in any of the shares mentioned. The Motley Fool UK has recommended Croda International Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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