Here’s how I’d use £200 a month to build a £3,417 second income – then double it!

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Earning a second income by taking on a second job might have financial benefits – but it could also be a big time commitment.

By contrast, putting some money into dividend shares could help me generate passive income. In other words, I could earn extra money but without needing to do extra work.

If I had a spare £200 each month, here is how I could use it to put that approach into action.

The basics of dividend shares

Dividends are basically one way for a company to distribute some, or all, of its spare cash.

That means not all shares pay them, even if they have in the past. A business may not generate spare cash, or it could decide it has other uses for spare money than to pay dividends.

So when looking for income shares to buy, I try to find strong businesses with attractive valuations that I think could pay me big dividends in future.

An example dividend share

Not only can a share stop paying dividends even though it has done in the past, it could run into even bigger unforeseen problems that mean its shares decline in value (to zero, in the worst case scenario). I therefore choose the shares I buy carefully and diversify my portfolio across a mix of businesses.

One of the shares I own for a second income is British American Tobacco (LSE: BATS). The Lucky Strike owner certainly faces some risks. Cigarette use is declining in many markets and the tobacco manufacturer saw total sales fall last year.

However, it is a free cash flow machine. Last year, its operating activities generated £10.7bn in net cash. The company maintained its Dividend Aristocrat status by increasing its dividend yesterday (9 February), as it has done annually for decades. The growth was modest (2%) but it underlined that the board still aims to keep growing the annual payout.

British American has a dividend yield of 9.2%. In other words, for every £100 I invest today I would hopefully earn £9.20 in dividends each year.

Building an additional income

What does that mean for my second income plan? Imagine I could target an average yield of 9% by investing in a mix of blue-chip shares. That is much higher than the FTSE 100 average yield, but as British American demonstrates, such yields exist even among blue-chip businesses.

If I invested £200 a month and reinvested my dividends, after a decade I ought to have a portfolio that could earn me £3,417 each year as a second income.

But wait. What if, instead of taking that income annually, I just kept compounding?

After 17 years I would have more than doubled my second income to £7,423 annually – all for a monthly investment of £200.

Like buying £1 for 51p

This seems ridiculous, but we almost never see shares looking this cheap. Yet this recent ‘Best Buy Now’ has a price/book ratio of 0.51. In plain English, this means that investors effectively get in on a business that holds £1 of assets for every 51p they invest!

Of course, this is the stock market where money is always at risk — these valuations can change and there are no guarantees. But some risks are a LOT more interesting than others, and at The Motley Fool we believe this company is amongst them.

What’s more, it currently boasts a stellar dividend yield of around 8.5%, and right now it’s possible for investors to jump aboard at near-historic lows. Want to get the name for yourself?

See the full investment case

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C Ruane has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. 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.