In my experience, three qualities make a good passive income stock. The first, most obviously, is a high yield. This is a function of the share price divided by the latest annual dividend, so it changes frequently.
However, I look for an average annual rate of 7%+. It is about 3% more than I make from the ‘risk-free rate’ (my 10-year UK government bonds’ yield). I see this as my compensation for taking the extra risk attached to shares.
The second quality is an undervalued share price on two basic measures. The first is relative to competitor shares, determined through valuation ratios including price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S).
The second is relative to what a share’s price should be based on projected future cash flows and is determined by a discounted cash flow (DCF) valuation. It is the key method for determining a share’s fair value.
And an undervalued share price reduces the chance of a loss being made should the stock need to be sold, in my experience.
And the final element I look for is earnings growth prospects for the underlying business. It is this that ultimately powers a company’s dividend and share price higher.
A prime example from my passive income portfolio
My passive income holding British American Tobacco (LSE: BATS) ticks all these boxes for me. It currently yields 7.7% and analysts forecast this will rise to 8.4% next year and 8.8% in 2026.
Additionally, it is undervalued on P/E, P/B and P/S measures, while a DCF analysis shows it to be 55% underpriced at its current £29.80. So, the fair value of the stock is £66.22, although it could go lower or higher than that.
A risk here is that its strategy shift away from combustible tobacco products towards non-combustible replacements stalls. This could allow its competitors to gain an advantage.
However, consensus analysts’ estimates are that its earnings will grow a stunning 44.1% a year to end-2026.
How much passive income can be made?
£11,000 is the average savings amount in the UK. My own holding in the firm is similarly-sized and I am very happy with that.
However, investors considering using this amount to generate passive income here would make £12,697 in dividends over 10 years on an average 7.7% yield.
This is also provided that they use the dividends paid to buy more British American Tobacco stock. This is called ‘dividend compounding’ and is a common practice in stock investing.
Continuing to use this, and provided the same average yield remains (it could go down or up), would generate £98,986 in dividends after 30 years.
The British American Tobacco shareholding would then be worth £109,986 (with the initial £11,000 investment included).
And this would generate £8,469 in passive income each year by then, or £706 a month!
The buying power of the income would have been somewhat reduced by then, assuming inflation over the period.
However, it underlines how a big passive income stream can be generated from a much smaller initial investment.
