Passive income is money made with minimal daily effort and when approached correctly the benefits can be enormous.
The best way I have found to make money while I sleep is to buy high-quality, high-dividend-paying shares. I started doing this in my mid-20s and the earlier the better for two key reasons, in my view.
First, it allows for the flattening out over time of any short-term shocks seen in the markets.
Second, it enables ever-greater returns to be made through ‘stock dividend compounding’. This is the same principle as compound interest in bank accounts, but rather than interest being reinvested, dividend payments are.
Stock selection for passive income
My main portfolio designed to generate high passive income is currently comprised of four stocks. These are M&G (LSE: MNG), Phoenix Group Holdings, Legal & General, and Aviva.
Each of them has similar qualities: a 7%+ yield, a growing business, and an undervalued share price.
M&G, for example, paid a 19.6p dividend in 2022, giving a current yield of 8.8%.
According to its H1 2023 results, the business is on track to generate £2.5bn of operating capital by end-2024. This on its own can provide a powerful engine for further growth.
Overall, adjusted profits before tax in H1 increased 31% to £390m against the same period last year. Consensus analysts’ expectations were for just £284m.
Analysts’ forecasts are now for earnings and revenue to grow, respectively, by 39.6% and 118.6% a year to end-2026.
A global financial crisis remains a risk for the stock, of course. As does inflation and interest rates remaining high, acting as a deterrent to new client business.
However, a discounted cash flow analysis shows M&G shares to be around 45% undervalued at their present price of £2.22. Therefore, a fair value would be around £4.04.
This does not necessarily mean that they will reach that level. But it does indicate to me that they are very undervalued. This reduces the chances of my dividend gains being wiped out by big share price drops.
The dividend-compounding miracle
£20,000 invested in shares like M&G’s that yield 8.8% would make me £1,760 in the first year.
If I took that money out and spent it, the next year I would only receive another £1,760.
Repeating this process, and based on the same average yield, would give me a total of £52,800 after 30 years.
Crucially, though, if I reinvested the dividends back into the stock, then after 30 years I would have £251,129!
This would pay me £20,312 a year in passive income, or £1,693 every month. This is based on the yield averaging 8.8% over the period.
A regular investment bonus
Great though this is, it could be even better if I continued to regularly invest each month – say £500.
If I did this, I would have the same (£20,312 a year, or £1,693 every month), after just 15 years!
After 30 years, provided the yield averaged 8.8%, I would have £1,162,121. This would pay me £97,320 a year in passive income, or £8,110 every month.
Certainly, inflation would impact the buying power of my income by that point. However, these figures underline how big passive income can result from much smaller initial investments.
