A second income is a common goal, providing financial security and the ability to relax once retired. It’s an opportunity to pursue long-forgotten hobbies, travel to dream destinations and spend time with loved ones.

There are many ways to earn extra income, some more passively than others. One of the most popular methods is investing in dividend shares. These shares pay a percentage of company profits to shareholders regularly. 

The percentage of the share price paid out is called the yield. By calculating an average yield, an investor can figure out how much capital’s needed.

An example

If the average yield of a 10-stock portfolio is 8%, then £10,000 will return £800. So to bring in £1,200 a month, what percentage is that? Since the yield’s represented annually it needs to be multiplied by 12 first, to get £14,400. That would be 8% of £180,000.

Ooof, that’s a lot!

Not many people have that kind of cash lying around. Fortunately, through the miracle of compounding returns, it’s possible to build that amount. How long it takes is unique to each investor. Naturally, starting sooner’s better and the more invested, the quicker it compounds.

Picking the right stocks is also key. A well-diversified portfolio might include a mix of growth and dividend shares from Europe and the US. A savvy investor may be able to secure a portfolio with an average return of 10%, combining dividends and growth.

With £10,000 invested in that portfolio, it would take around 29 years to reach £180,000. By contributing an additional £200 a month, it could shave the time down to around 18 years!

This would also require using a dividend reinvestment plan (DRIP) to accelerate the growth. Depending on market conditions, it could take more or less time.

A diversified portfolio

The average annual price return of the FTSE 100 has been 6.8% since 1984. US indexes like the S&P 500 have done better, with an average of 11.65%. A mix of stocks is a good way to achieve both growth and stability.

Some examples of high-growth US stocks include Shopify, PayPal and Nvidia. In the UK, popular dividend stocks include Tesco, Legal & General and Vodafone (LSE: VOD).

Vodafone’s been struggling for years, with the stock down 56% since 2020. Even though revenue and adjusted earnings grew 5% and 2.2% respectively, regulatory changes led to a drop in revenue in Germany. 

With debt already high, any risk of further losses could force it to cut dividends – again! The 8.4% yield looks very attractive but last year’s dividend cut shook investor confidence.

In an attempt to reverse its fortunes and revamp the company, Vodafone made two key business decisions last year: the sale of its Italian division and a merger with fellow UK telecoms firm Three. The proceeds from the Italian sale have helped fund a €2bn share buyback programme, reconfirming its commitment to shareholders. 

If things come together, it could make a solid recovery. With a high yield and low price-to-earnings (P/E) ratio (8.5), I think it’s an undervalued stock worth considering for passive income.