Have you ever wondered if dividends can really generate a useful second income?

Sure they can, but whether they will depends on a few factors: how much a person invests, for how long, and what the dividend yields are. To illustrate, what type of second income could someone make with £20,000?

Take the long-term view

As I just mentioned, the time frame is important. I support a long-term approach to investing. This gives companies time to prove themselves and, hopefully, accumulate profits.

There are two ways to draw a second income. One is to invest £20,000 and start withdrawing the profits as soon as they arrive. At a return of 5%, for example, this should produce a second annual income of £1,000.

But an alternative approach is what’s known as compounding: reinvesting the profits initially. Then, at some point, the profits can be converted to be used as income rather than further compounded.

For example, after 10 years, at a CAGR of 5%, the portfolio should be worth around £32,578. With a dividend yield of 5%, this should produce a second income of around £1,628 per year.

Alternatively, continue to accumulate for a further 10 years, and the portfolio must then be worth more than £53,000. With a dividend yield of 5%, this could produce a second income of £2,653 per year.

Never

Diversification is a simple but important risk management strategy: £20,000 is enough to spread across multiple stocks.

Trading fees and commissions can also eat up money, so a smart investor should weigh up his options when it comes to choosing a shares trading account or stocks and shares ISA.

Great profit motive

You mentioned a target return of 5% as an example. In fact this is slightly larger than the current FTSE 100 index Yield 2.9%. But I believe it is still possible with a commitment to excellent, high-quality companies.

The only income share I think investors should consider is… British American Tobacco Company (LSE: bat). The company has a global footprint, a strong distribution network and a stable portfolio of premium brands such as Lucky hit Which gives it pricing power.

Raising prices can help mitigate falling sales volumes, but only so far, if volumes fall badly enough.

British American offers a dividend yield of 5.6%. The expected return is actually higher, as British American aims to continue growing its earnings per share annually, as it has done for decades.

However, dividends are not guaranteed, and declining cigarette sales pose a risk. Moreover, the company lost significant share in major markets last year. As the market size shrinks, maintaining or increasing share will be better for performance.

Meanwhile, the company is also growing its non-cigarette business while cigarette use declines.

From an ethical perspective, not all investors are comfortable with tobacco stocks. Personally, I think the stock has great continued earnings potential.