£10,000 in savings? Here’s how I’d try to turn that into £1,392 a month of passive income!

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

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Maximising passive income made from investing in high-dividend-paying shares has been my core investment strategy since turning 50.

This is because I want to continue to reduce my working commitments while enjoying a high standard of living.

Stock selection is key

My core portfolio geared to making me high passive income currently consists of six stocks. These are Phoenix Group HoldingsBritish American Tobacco (LSE: BATS), Imperial Brands M&GLegal & General, and Aviva.

They were all chosen according to three main criteria.

First, they must pay me a 7%+ return every year. The reason is that I can get 4%+ from risk-free investment in UK government bonds, and stocks are riskier.

Aviva currently pays less than this, but other stocks paying more counterbalance it. At the moment, my core high-yield portfolio makes me an 8.5% a year return.

Second, the businesses must look poised for further strong growth to me. Consensus analysts’ expectations are that British American Tobacco, for example, will see its earnings increase by 56% annually to end-2026.

Earnings per share are expected to rise by 53% a year over that period. And return on equity is predicted to be 16% by the same point.

A delay in switching from tobacco products to nicotine substitutes is a risk in the stock. This could lose it some competitive advantage in the sector. Potential legal action for health problems caused by its products in the past is another risk.

However, to me, these growth numbers indicate it will grow very strongly and will continue to pay very high dividends. Currently, it yields 9.7% a year.

Third, my high-yield stocks also need to look undervalued against their peers. After all, I don’t want my dividend gains wiped out by share price losses.

British American Tobacco, for instance, trades on the key price-to-earnings (P/E) stock valuation measurement at just 6.2, against a peer group average of 12.1.

The stock looks around 58% undervalued at the present price of £23.76, based on a discounted cash flow analysis. Therefore, a fair value would be around £56.57.

This doesn’t mean it will reach that price, but it confirms to me that it looks very undervalued.

Reinvesting dividends is also essential

The other key part of maximising returns from my passive income portfolio is to reinvest the dividends paid to me.

For example, a £10,000 investment in British American Tobacco would pay me £970 this year in dividends. I would make another £9,700 over 10 years if I withdrew the dividends every year and spent them.

Crucially though, if the payout averaged 9.7% annually over 10 years, and I reinvested the dividends back into the stock, then I would have made another £16,277 instead!

My total stake in British American Tobacco would have gone up to £26,277. This would pay me £2,420 a year in dividends, or £202 a month.

Over 30 years if the yield averaged the same, I’d have £181,433, paying me £16,708 a year, or £1,392 every month.

Inflation would reduce the buying power of my money, of course. But it shows that smaller investments in the right stocks can make much bigger returns over time if the dividends are reinvested.

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 positions in Aviva Plc, British American Tobacco P.l.c., Imperial Brands Plc, Legal & General Group Plc, M&g Plc, and Phoenix Group Plc. The Motley Fool UK has recommended British American Tobacco P.l.c., Imperial Brands Plc, and M&g 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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