I am a big fan of passive income as it is money made with minimal effort on my part. And the best way I have found of generating it is through dividends paid by shares.
All I need do is to pick the right stocks initially and then monitor their progress periodically after that.
Constructing a strong portfolio of high-yielding shares has given me a much better lifestyle than I would have enjoyed otherwise. And it should allow me to keep reducing my working commitments to an early retirement.
What are the ‘right stocks’?
The first of my three key criteria in picking my passive income shares is an average annual yield of 7%+. This figure reflects the compensation I want for taking the additional risk of investing in shares over the ‘risk-free rate’. This is the yield on 10-year UK government bonds, which is currently around 4.6%.
My second criterion is that the stock should look undervalued to me. This reduces the chance of my losing money on the price should I ever sell the share. Conversely, it increases the possibility that I will make money on the share price in that event.
The third quality I look for is that the underlying company has strong earnings growth potential. It is ultimately this that will power its share price and dividend higher over time.
An enduring passive income gem
Legal & General (LSE: LGEN) has been a core passive income stock holding for me for a long time.
To begin with, the financial services giant currently yields 8.7% compared to the average FTSE 100 return of 3.5%. That said, analysts forecast that its dividend will increase to 8.9% this year, 9.1% next year, and 9.2% in 2027.
Secondly, a discounted cash flow analysis shows the stock is 55% undervalued at its present price of £2.45. So the fair value for it is £5.44, although market vagaries might push it lower or higher.
A risk to this is a continued rise in the cost of living that may cause some customers to cancel their policies.
However – and my third passive income stock requirement met – analysts forecast its earnings will increase 29.3% each year to end-2027.
How much passive income can be generated?
Investors considering a holding of £11,000 (the average UK savings) in Legal & General would make £957 in first-year dividends.
Over 10 years on the same average yield, this would rise to £9,570, and over 30 years to £28,710.
This is a lot more than could be made from a standard UK savings account. But it could be vastly greater if the dividends were reinvested back into the stock – known as ‘dividend compounding’.
The magic of dividend compounding
By using this standard investment practice with the same average yield, dividends after 10 years would be £15,174, not £9,570.
And after 30 years on the same basis, this would increase to £137,188 rather than £28,710.
The total value of the holding would be £148,188, which would pay £12,892 in annual passive income by then.
I also believe its strong earnings growth potential should drive the share price and dividend much higher over time. Therefore, I will be adding to my holding in Legal & General very soon.
