ASX shares can be a very effective tool to build a second income for Australians looking to grow their earnings.
A lot of working Aussies get most of their taxable earnings from their main source of work, whether that's conducted at home, at the office, in a shop, at a construction site or anywhere else for that matter.
But we can only work so many hours. Even if we worked 10-hour days six days a week, there's an upper limit to what we can achieve with our time.
Wouldn't it be good if we could find a second income that can keep working while we're not?
Dividends are great
A lot of the larger companies on the ASX make a profit, with many of those deciding to pay a dividend to shareholders each year.
We can buy a small piece of those businesses by investing in ASX shares. As shareholders, we do not try to influence what decisions the CEO should make or what strategy a company should take. We can just be passive, backseat investors and benefit from the dividend payments and, hopefully, share price growth over time.
The first step to building a second income is to actually save some money and invest it in whatever ASX shares we decide are good options.
Imagine a company that pays a dividend yield of 4%. That means a $1,000 investment would generate $40 in dividends in year one.
If the business grows its earnings per share (EPS) by 10%, it could theoretically lead to a 10% rise in the dividend and perhaps deliver a 10% share price increase. Of course, it may not be as simple as that in real life, but this is an example of how things can work.
After one year, we'd have a 14% total return – that's the 10% share price growth and the 4% dividend yield.
Plus, the next year of dividend payments would equate to a 4.4% dividend yield on the cost of the shares after the 10% dividend increase by the business.
Aside from making the initial investment, I wouldn't have had to put any work myself into generating those dividends.
How I'd invest in ASX shares to make a second income
Many company management teams have the wonderful ability to deliver growth by investing in initiatives and re-investing profit back into the businesses.
I believe ASX shares that are capable of producing a mixture of dividends and good earnings growth could suit my investment income goal the most.
While names like ANZ Group Holdings Ltd (ASX: ANZ) and BHP Group Ltd (ASX: BHP) usually deliver impressive dividend yields, I'm not sure that their profit is going to grow at a strong compound annual growth rate (CAGR) because of their size and the nature of banking and mining.
I'm looking for good businesses that have plenty of room for growth, are among the best at what they do, generate good margins and have plans to keep becoming bigger.
Which ASX shares do I think can deliver good earnings and dividend growth over the rest of the 2020s and hopefully beyond? And are they currently at a good price?
Diversification is important, so I'll mention five names that could be a good place to start researching with a look at their investor presentations. They include:
- Johns Lyng Group Ltd (ASX: JLG)
- Lovisa Holdings Ltd (ASX: LOV)
- GQG Partners Inc (ASX: GQG)
- Wesfarmers Ltd (ASX: WES)
- Washington H. Soul Pattinson and Co. Ltd (ASX: SOL)
Good exchange-traded funds (ETF) could also be effective at delivering returns, such as VanEck Morningstar Wide Moat ETF (ASX: MOAT) or VanEck MSCI International Quality ETF (ASX: QUAL).
Second income example
Let's imagine that we're starting off with savings of $5,000 and investing $200 per month into an (ASX) share portfolio that makes an annual return per annum of 10%. Assuming we re-invest the dividends, it could grow to be worth $931,000 in 35 years.
With a reasonable dividend yield of 5.5%, the portfolio could make $51,000 of a second income per year. That sounds great to me. Of course, we can start accessing our investment income in year one if we want extra cash flow earlier, though the long-term portfolio growth would be less.
