The best way I have found to generate passive income (money made with minimal daily effort) is to invest in high-yielding shares.
I then use the dividends paid me to buy more of the shares to create a virtuous money-making cycle — known as ‘dividend compounding’.
So, the more shares I buy, the more dividends I am paid, and the more shares I can buy and so on.
The key factors in my share selection
First I look for a yield above 7%. Why this figure? Because I can obtain 4%+ from the 10-year UK government bond – the ‘risk-free rate’ – and shares are riskier.
Second, as I do not want all my dividend gains erased by share price losses, I only buy stocks that look undervalued to me.
And finally, as dividends (and share prices) are driven by business expansion, I look for strongly growing firms as well.
I recently added to my holding in British American Tobacco (LSE: BATS), using these key criteria.
Why this share?
The company paid a dividend of 230.89p a share in 2023, giving a current yield of 9.6%. This is more than double the present average FTSE 100 yield of 3.8%.
Moreover, consensus analysts’ estimates are that its dividend in 2024, 2025, and 2026 will be 236.70p, 246.50p, and 258.80p, respectively.
Based on the current £24.11 share price, this would give yields of 9.8%, 10.2%, and 10.7%.
In terms of the share’s valuation, a discounted cash flow analysis shows it to be around 53% undervalued. Therefore, a fair value would be around £51.30.
This does not guarantee it will reach that price, but it underlines to me how undervalued it still looks.
There are risks in the shares, as in all stocks, of course. One here is that its ongoing transition away from tobacco products to nicotine substitutes is delayed for some reason. Another is any litigation from the effects of its products in the past.
However, consensus analysts’ estimates are that its earnings will grow 51.6% every year to the end of 2026.
High yield with a turbo boost
Based on the current yield, £1,000 invested in the firm would make £96 in the first year.
If I withdrew that money and spent it, then I would make another £96 only next year, provided the yield remained the same. After 10 years of doing this, I would have made £960 to add to my £1,000 initial investment.
Not bad, but it is nothing to what can be achieved if I reinvested the dividends back into the stock.
Doing this would give me an extra £1,602 instead of £960 after 10 years, provided the yield averaged 9.6%. My total investment pot at that point would be £2,602.
Over 30 years on the same basis, the total would be £17,611, paying £1,691 a year, or £141 each month!
Inflation would reduce the buying power of the income, of course. And there would be tax implications according to individual circumstances.
However, it highlights that significant passive income can be generated from much smaller investments in the right stocks if the dividends are reinvested.
