Legendary investor Warren Buffett best encapsulated the ethos behind the passive income investment idea, I think. He said, “If you don’t find a way to make money while you sleep, you will work until you die”.
Investing in shares that pay dividends is the best way I have found so far to generate high and regular passive income.
The earlier this journey is started, the better, in my view. It allows a greater period for dividend payments to be made. And it also allows the market and individual stocks more time to recover from any short-term shocks.
Three other important considerations
Selecting the shares is the only real effort involved in this method of making passive income, but it is vital. Aside from choosing stocks that pay a high yield, two other factors are key to me in the shares I select.
First, they must have good earnings growth prospects, as this is what drives dividends (and share prices) higher over time.
And second, they must be underpriced both compared to their peers and their value based on future cash flow projections.
After all, I do not want my dividend income wiped out by sustained share price losses. This is less likely to happen with stocks that are undervalued, in my experience.
A current case in point
One company I have been looking at recently is FTSE 100 telecoms giant Vodafone (LSE: VOD).
In 2023, it paid a dividend of 9 euro cents (7.6p) a share. This gives a yield of 10.1% on its current 75p share price – nearly triple the FTSE 100 average of 3.5%.
Consensus analysts’ estimates are that its earnings will grow by 22% every year to the end of 2026.
A risk to this is the high level of competition in the sector that may squeeze profit margins. Another is the heavy infrastructure investment required to keep pace with rivals, which may increase debt.
That said, currently Vodafone is trading 70% lower than future cash flow projections indicate it should. This discounted cash flow assessment shows a fair value for the stock should be £2.50, although it may go lower or higher than that, given the vagaries of the market.
How much passive income could be made?
Given its 10.1% yield, £9,000 (the amount I started investing with 30 years ago) would make £909 in dividends in the first year. Over 10 years on the same average yield, this would rise to £9,090 and over 30 years to £27,270.
A nice return certainly, but much more could be made by using the dividends to buy more Vodafone shares.
Doing this – ‘dividend compounding’ – would generate £15,606 in dividends after 10 years, on the same average 10.1% yield, not £9,090. And over 30 years, it would be £174,928, rather than £27,270!
This would pay an annual passive income of £17,668 at that point, or £1,472 each month!
Assuming inflation over the period, the buying power of the money would be reduced. However, it shows that high passive income can be built over time from a much smaller investment if the dividends are compounded.
I already have several very high-yielding shares, so do not need another. If I did then I would buy Vodafone for its dividend, undervaluation and earnings growth prospects.
