Passive income is money earned from minimal daily effort. And anyone with an income can make it and then turn it into a sizeable investment pot, in my view.
The way I did it initially was to invest around 20% of whatever I earned into shares that paid dividends.
The current median average salary in the UK is £34,963 a year, so after taxes it would leave £28,245. This is around £2,354 a month, so 20% of that is about £471 a month.
I cannot stress enough that no set minimum amount is required to make significant passive income. Even small amounts invested regularly can produce much bigger returns.
Big things have small beginnings
Using the UK average salary example, £471 a month could be invested into one of several high-dividend-paying FTSE 100 stocks.
British American Tobacco (LSE: BATS), for example, pays a 9.75% dividend currently and is part of my own high-yield portfolio.
Just £471 invested monthly in this stock could produce a £97,129 investment pot after 10 years. This would pay £8,744 a year in dividends, or £729 a month!
This is on two provisos. First, the yield averaged the same (it could be less, or more, as dividend payouts and share prices change).
And second, the dividends paid out are reinvested back into the stock – known as ‘dividend compounding’. This is the same process as leaving interest paid in a bank account to grow over time.
On the same two provisos, this £471 a month over 30 years could grow into £1,026,427. This would pay £94,742 in dividend yield a year, or £7,895 a month!
How to choose the stocks
In my case, three factors are key in stock selection.
First, it needs a yield of at least 7% — but the higher the better, provided the stock quality remains good.
Second, its shares should appear to me to be undervalued against their peers, using various financial measurements. British American Tobacco, for instance, is currently trading on the key price-to-earnings (P/E) ratio at just 6.1. This compares to a peer group average of 7.8, so it looks undervalued to me.
Additionally, a discounted cash flow analysis shows the stock to be around 55% undervalued at its present price of £23.70. Therefore, a fair value would be around £52.67, but this does not necessarily mean it will ever reach that level.
The third key factor in my stock selection is how the core business looks. In British American Tobacco’s case, it is transitioning away from tobacco products and towards non-combustible nicotine products, such as vapes.
So far, this appears to be going well. Its 2023 results showed adjusted profit from operations rose 3.1% in 2023 from 2022 – to £12.47bn. Analysts’ expectations are that its earnings and EPS will rise respectively by 71% and 65.1% a year to end-2026.
There are risks for me to monitor, of course. One is that its business transition is delayed for some reason. Another is any litigation from the effects of its products in the past.
This said, over time everyone will develop their own methodology for choosing stocks that are right for their investment portfolio.
Ultimately, though, good choices, regular investment, and dividend compounding are all that are required to make significant passive income over time, in my experience.
