Passive income is essentially money made with minimal daily effort on the part of the investor. And as Warren Buffett said: “If you don’t find a way to make money while you sleep, you will work until you die.”
The best way I’ve found to make money while I sleep is to buy high-dividend-paying shares. I started to do so in my mid-20s and the earlier the better, in my view. This allows for the flattening out of any short-term shocks seen in the markets.
It also enables greater returns to be made through ‘dividend compounding’. This is the same principle as compound interest in bank accounts, but rather than interest being reinvested, dividend payments are.
Crucially as well, the earlier it’s done, the more dividend compounding allows significant returns to be made from relatively small investments.
Stock selection
The FTSE 100 index currently has many high-quality stocks that pay notably high dividends. Several combinations of these shares will provide an average yield of 9.25%. This compares to an average payout from the index of 3.8%.
Having made a high-yield shortlist, I then look for shares that appear undervalued compared to their peers. I use several stock valuation metrics for this, with the most important for me being price-to-earnings, price-to-book, and discounted cashflow.
My rationale is that I want to minimise the chance that my dividend gains are nullified by share price losses.
After this, I look at how strong the underlying business seems to ascertain if it’s on a sustainable uptrend. This includes examining short-term and long-term asset and liability ratios, new business initiatives, and senior management capabilities, among other factors.
The dividend compounding effect
When I started investing, I wanted to make more on my savings than I did from the bank. I began with a pot of around £9,000.
If I had invested that in shares that paid dividends averaging 9.25% a year, I would have made £832.50.
If I had taken that out of my portfolio and spent it, I would only have received another £832.50 the following year. Over 10 years, I would have made £8,325, provided the average payout remained the same.
This is better than the rate I was getting at the bank. But it’s nothing to what I would have made if I’d left the dividends in to be compounded.
By using the dividends paid to me to buy more of the stocks, my investment pot would have been £21,800 after 10 years. After 24 years, it would have been £75,224, paying me £531 in passive income every month.
A regular investment bonus
However, continuing to invest, say £500, every month would result in the same sized-pot after around seven years, through dividend compounding. And after 24 years, it could total £613,533, paying £53,762 a year in dividends – or £4,480 a month.
These figures assume the average yield remains the same over the periods. It may go down as well as up, depending on share price movements and dividends paid.
Inflation would also reduce the buying power of the income, of course. And there would be tax implications according to individual circumstances. But the figures really do show what can be achieved.
