Passive income is money earned through minimal daily effort, which is the sort of idea I like.
Through relatively little work, this new stream of income can provide more choices in life. A better place to live, more exotic holidays, and even the opportunity to work less or to retire early.
For me, there has been no better way of doing this than buying high-quality stocks that pay high dividends.
I have five stocks in my high-yield portfolio. They are Phoenix Group Holdings yielding 10.2%, M&G at 8.7%, Legal & General at 8%, Aviva at 6.9%, and British American Tobacco (LSE: BATS) at 10%.
However, for me it is not enough that the stocks pay high dividends.
They also need to have a strong core business, so they can continue to pay me high yields.
And they must also appear to be undervalued against their peers. I do not want my dividend gains erased by share price losses, after all.
Ticking all the boxes
I recently added British American Tobacco to my high-yield portfolio because it ticked all these boxes for me.
It has a history of paying high yields. Aside from the current 10%, the yields in 2022, 2021, and 2020 were 6.7%, 7.9%, and 7.8%, respectively.
The core business is currently transitioning away from combustible (tobacco) products to non-combustible (vapes and patches) ones.
This appears to be going well so far. Adjusted profit from operations rose 3.1% in 2023 from 2022 to reach £12.47bn. Adjusted diluted earnings per share (EPS) increased 4% over the same period to 375.6p. And adjusted net debt fell 7.4% to £33.94bn.
One risk here is that its transition away from traditional products is delayed for some reason. Another is any litigation from the effects of its products in the past.
Yet the shares currently trade on the key price-to-earnings (P/E) measurement at just 6.1, against a peer group average of 11.8.
A discounted cash flow analysis shows the stock to be around 57% undervalued at the present price of £22.95. Therefore, a fair value would be around £53.37.
The shares may not necessarily ever reach that point, but it underlined to me that they are very good value.
Maximising dividends through compounding
‘Dividend compounding’ is the same principle as compound interest in bank accounts, but rather than interest being reinvested, dividend payments are.
The difference in returns between withdrawing my dividends paid each year and reinvesting them is massive.
For example, 436 shares in British American Tobacco would cost me just over £10,000.
The 10% dividend on these shares would make me £1,000 in the first year. If I withdrew that, I would receive another £1,000 the following year, provided the dividend remained the same.
If I kept withdrawing my payouts and the dividend stayed the same, I would have made £30,000 after 30 years.
However, if I reinvested the dividends back into British American Tobacco stock, I would have £198,374 after 30 years. That would pay me £18,803 a year in passive income, or £1,567 every month.
This is provided the yield averages the same – it may go down or up, as dividends and share prices change. And inflation would affect the buying power of my income.
However, it highlights that big passive income can be generated from a much smaller initial investment.
