£17,000 in savings? Here’s how I’d aim to turn that into a £29,548 annual second income!

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A second income provides an additional safety net against the unexpected things that sometimes happen in life.

It can also be used to build a better standard of living for ourselves and those closest to us.

The best way I have found of generating this additional source of income is buying high-quality, high-yielding shares.

Picking the right companies

There are three key points on my checklist for shares that I buy. I recently added to my holding in M&G (LSE: MNG) for these reasons.

The first thing I look for is an annual yield of over 7%. Why this figure? I can make 4%+ from buying the risk-free 10-year UK government bond, and shares are not risk-free.

M&G paid a total dividend in 2023 of 19.7p a share. This gives a yield of 9.8% on the current share price of £2.02.

This is one of the highest yields in any of the major FTSE indexes. By comparison, the current average yield in the FTSE 100 is 3.8% and in the FTSE 250 it is 3.4%.

Growth prospects?

The second thing I look for is a strong growth outlook for the firm. This is what powers gains in both share price and dividends over time.

A risk for M&G is its relatively high debt-to-equity ratio of around 1.9. Another is a genuine new global financial crisis.

However, its 2023 results showed a 28% rise in adjusted operating profit from 2022 — to £797m. Operating capital also rose — by 21% year on year, to £996m – taking the total to £1.8bn over 2022 and 2023.

Overall, consensus analysts’ expectations are that M&G’s earnings will grow at 18.8% a year to the end of 2026.

Undervalued?

The final thing I look for is that the share appears undervalued against its peers. This lessens the chance of a major share price slide wiping out my dividend gains.

In M&G’s case, it currently trades on the key price-to-book (P/B) stock valuation measure at just 1.2.

This looks very undervalued compared to the average 3.6 P/B of its peer group.

But how much of a bargain is it? A discounted cash flow analysis shows the stock to be around 48% undervalued against its competitors.

So, with the shares currently at £2.02, a fair value would be about £3.88, although it might never get there.

Turbo-charged dividends

Once I have bought a high-yielding share, I use the dividends paid me to buy more of the stock. This is called ‘dividend compounding’, and it dramatically increases the dividend payouts over the long term.

For example, £17,000 – the average UK savings account amount — invested at 9.8% would make £1,666 in the first year. After 10 years on the same yield, I would have another £16,660.

However, if I reinvested those dividends back into the stock, I would have made another £28,116 instead of £16,660.

After 30 years of doing this with an average 9.8% yield, I would have £317,753. This would pay me £29,548 a year in dividends or £2,462 a month!

Yields can go down as well as up, of course, depending on dividend payments and share prices.

However, given its strong business outlook, high yield, and undervaluation, I may well be adding even more shares to my M&G holding very soon.

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Simon Watkins has positions in M&g Plc. The Motley Fool UK has recommended M&g 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.