Money made from minimal effort is often referred to as ‘passive income’. And by far the best way I have found of generating it is from dividends paid by shares.
The only significant effort involved is picking the right stocks in the first place. After that, it is just a case of monitoring their progress every now and again.
Despite the negligible labour required, the level of passive income generated can be life-changing. It can make for a much more comfortable daily existence and can allow for an early retirement.
So what are ‘the right stocks’?
I look for three qualities in the shares I choose for passive income purposes.
The first is a good yield. This can change as it is based on a stock’s share price and dividend. However, my minimum starting requirement is around 7% a year.
This is because I can usually get around 4% from the 10-year UK government bond – the ‘risk-free rate’ – and shares are not risk free.
The second facet I look for is an undervaluation in the share price. This reduces the chance of my making a loss on the stock if I want to sell it. Conversely, of course, it increases the possibility that I will make a profit on the share price in that event.
I generally look for an undervaluation of at least 20% from its fair value, based on a discounted cash flow (DCF) analysis. This assesses a stock’s price relative to where it should be, based on future cash flow forecasts.
And the final thing I want is a business strong enough to support the current dividend and to raise it over time. Consequently, I want a firm with high earnings growth forecasts, as these ultimately power a dividend (and share price) higher.
A case in point
BP (LSE: BP) currently delivers a yield of 5.4%. However, analysts forecast this will increase to 6.2% in 2025, 6.5% in 2026, and 6.8% in 2027.
Its present price of £4.20 looks 60% undervalued to me on a DCF basis. So a fair value for the stock is technically £10.50, although the market might push it lower or higher.
A risk here is that the supply and demand balance of the market tips into a long-term bearish trend.
Nonetheless, consensus analysts’ forecasts are that its earnings will grow a stunning 23.8% every year to the end of 2027. I think this should push the dividend and share price much higher.
How much passive income can it make?
Investors considering an £11,000 (the average UK savings amount) holding in BP would make £7,853 in dividend income after 10 years. This is based on the current 5.4% staying the same over the period (which is not guaranteed). It also factors in that the dividends paid out are reinvested into the stock (known as ‘dividend compounding’).
On the same twin provisos, the same investment will make £44,382 in dividend income after 30 years.
Adding in the initial £11,000, the total holding would by then be worth £55,382. This would pay £2,991 a year in passive income.
Given its strong earnings growth potential, and what this might mean for the dividends and share price, I will be adding to my existing BP holding very soon.
