£20,000 in savings? Here’s how I’d aim to turn that into a £16,075 annual second income

This FTSE 100 stock pays a high dividend that could make me a big second income. It looks undervalued and has a growing business.

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A second income gives anyone more options in life, so the higher the better as far as I am concerned. And if it can be made from very little effort on a daily basis, then better still.

The best way I have found of achieving this has been through investing in shares that pay high dividends. Having selected the right stocks, the only subsequent work is ensuring that they are performing as they should.

Stock selection

I recently increased my holding in Imperial Brands (LSE: IMB), so this is a good example of my process.

First, of course, each stock needs to pay at least a 7% yield. Why 7%? Because I can get 4%+ risk-free from the 10-year UK government bond, and stocks are not risk-free.

Imperial Brands paid a dividend of 146.82p a share in 2023. On the current £18.69 share price, that gives it a yield of 7.9%.

Second, a stock needs to look set for strong growth. Earnings drive dividend payments, so if the former grows over time then the latter will likely do the same.

For Imperial Brands, consensus analysts’ estimates are that earnings per share will increase by 5.2% a year to end-2026. Return on equity is forecast to be 52.5% by that time.

A risk in the stock is that this transition falters, allowing its competitors to gain market share at its expense. Another risk remains future legal action for health problems caused by its products in the past.

However, 9 April saw a company update stating that H1 adjusted profit this year will be higher than in H1 2023. Last year, operating profit increased 26.8% over the previous year — to £3.4bn. Earnings per share also increased sharply — by 52.1% to 252.4p.

Undervalued?

The third factor for me is that a stock should look undervalued to me compared to its peers. This is to lessen the chance of a big, sustained share price fall wiping out all my dividend gains.

In Imperial Brands’ case, it trades on the key price-to-earnings (P/E) stock valuation measurement at just 6.8. Its peer group averages 14.6, so it is undervalued on that basis.

By how much? A discounted cash flow analysis shows it to be around 63% undervalued right now.

Its fair value, then, is around £50.51, compared to the current £18.69. There is no guarantee it will reach that fair value price, of course.

Big second income generator

So, £20,000 invested in Imperial Brands shares yielding 7.9% annually, will give a total investment pot of £43,954 after 10 years. This would pay £3,328 a year in dividends, or £277 each month.

This is provided the yield averages the same (it may go up but could also fall) and the dividends are reinvested into the stock. This is known as ‘dividend compounding’ and is the same idea as compound interest in a bank account.

Over 30 years, on the same basis, the investment pot would be £212,293. This would pay £16,075 a year in dividends, or £1,340 each month.

Inflation would reduce the buying power of the income, of course. However, it highlights that a significant passive income can be generated from relatively small investments in the right stocks 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 Imperial Brands Plc. 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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