£9,000 in savings? Here’s how I’d try to turn that into £581 a month of passive income

Relatively small investments in high-yielding stocks can grow through the power of dividend compounding into significant passive income.

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When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

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Legendary investor Warren Buffett encapsulated the idea at the heart of passive income investment. He said: “If you don’t find a way to make money while you sleep, you will work until you die.”

The best way I have found to make money with minimal daily effort is to invest in high-dividend-paying shares.

Stock selection process

I am considering adding Imperial Brands (LSE: IMB) to my high-yield portfolio, given its present yield of 8.1%.

Positive for me is its history of paying generous dividends. Over the past four years, working back from 2022, it made payouts yielding 7.6%, 8.9%, 10.1%, and 11.3%, respectively.

My next consideration is whether I think the business is growing, so it can pay me greater dividends over time.

Imperial Brands is currently transitioning away from tobacco products and towards nicotine replacement products, such as vapes. This appears to be going well, with its nicotine replacement goods’ net revenue up 26% in 2023 compared to 2022.

Overall, reported operating profit in 2023 grew 26.8% year on year — to £3.4bn.

It is at this point that I look at the key risks as I see them. One here is its huge net debt of £8.72bn. For me, though, two factors mitigate this risk somewhat.

First, its net debt has not increased from a year ago. And second, it has an EBITDA ratio of around 2.3. This means it can easily cover the interest on this debt.

Another risk remains future legal action for health problems caused by its products in the past. Again, its high earnings mean it can afford to settle such litigation relatively easily. And as it completes its transition away from tobacco products, this risk should diminish, I think.

My final consideration is whether the shares look undervalued against their peers. I do not want my dividend gains erased by a big price fall, after all.

On the key price-to-earnings (P/E) stock valuation measurement, Imperial Brands is trading at just 6.7, against a peer group average of 13.8.

discounted cash flow analysis shows the stock to be around 56% undervalued at the present price of £18.18. Therefore, a fair value would be around £41.32, although it may never reach that level, of course.

Overall, for me, it ticks all three boxes, so I will be buying the stock very soon.

What returns can be made?

My £9,000 invested in Imperial Brands now would yield me £729 this year in dividends. If I took this payment out of my portfolio, then I would have the same return next year.

This is provided the yield remains the same, but it can go down or up, depending on share price and dividend payouts.

After 30 years of this, I would have made £21,870.

Not bad, but nowhere near what I could make if I reinvested the dividends paid to me back into the stock. This is known as ‘dividend compounding’ and is the same process as leaving interest in a bank account to grow.

By reinvesting the dividends (averaging 8.1%), I would have made £93,114 instead! This would pay me £6,977 a year, or £581 a month.

Inflation would erode the buying power of this. But it does underline that big returns can come from much smaller investments over time, using dividend compounding.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Simon Watkins has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands 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.

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