The best way I have found of generating passive income (money made with minimal work) is share dividends.
Picking the right high-quality stocks that pay high yields is the only real effort required in this. After that, all that is needed is to monitor the stocks’ progress every now and again.
Such shares will continue to pay dividends regardless of whatever else I might be doing, including sleeping. And as legendary investor Warren Buffett put it: “If you don’t find a way to make money while you sleep, you will work until you die.”
Selecting the stocks
Ultimately, it is a firm’s earnings growth that will drive its dividend (and share price) higher. So, this is a key quality I look for in stocks intended to make me high passive income.
Another facet I want is for the share to be undervalued on two fronts. This lessens the chances of passive income gains being wiped out by share price losses if the stock is sold.
So, first I want the shares to look undervalued against comparable stocks. And second, against where the stock price should be, based on future cash flow projections for the firm.
Finally, of course, I want a high yield. This will make me more passive income in the short term and if reinvested wisely could lead to stellar long-term returns.
A good case in point
FTSE 100 global investment manager M&G (LSE: MNG) is a prime example of this selection process, in my view, and is worth considering.
Analysts forecast its earnings will grow 30.1% each year to the end of 2027. A risk to these over time is intense competition in the sector.
However, the stock looks very undervalued against its competitors on both the price-to-book (P/B) and price-to-sales (P/S) ratios. On the former, it trades at just 1.3 against a peer average of 3.6. And on the latter, it is at 0.7 against a 4.3 peer average.
A discounted cash flow analysis shows the shares are 59% undervalued at their present price of £1.99. So, a fair value would be £4.85, although market vagaries could push it lower or higher.
And finally, it yields 9.9% now. However, analysts forecast this will rise to 10.4% in 2025, 10.8% in 2026, and 11.6% in 2027.
How much passive income can it make?
I started with a £9,000 holding in M&G and investors considering the same would make £891 in dividends in year one.
Given an average 9.9% yield, this would increase to £8,910 after 10 years and to £26,730 after 30 years. But none of this is guaranteed, of course.
Crucially, however, if these dividends were used to buy more M&G shares – known as ‘dividend compounding’ – the returns could be much greater.
Using this common investment method on an average 9.9% yield would generate £15,123 in dividends after 10 years, not £8,910. And after 30 years on the same basis, it would make £164,303 rather than £26,730!
Adding in the initial £9,000 investment, the total M&G holding would be worth £173,303. This would pay £17,157 a year in dividends by then, or £1,430 each month!
Inflation would reduce the buying power of this income at that point. However, it underlines that much smaller initial investments in the right passive income stocks can generate huge returns over time.
