Legendary investor Warren Buffett best summed up the idea behind passive income investments. He said: “If you don’t find a way to make money while you sleep, you will work until you die.”
The best way I have found of generating such income is by investing in high-yield shares with certain other qualities.
I then effectively turbocharge the dividends they pay by reinvesting them back into the stocks. This is known as ‘dividend compounding’ and is like leaving interest in a bank account to grow.
Qualities I want in income stocks
The beating heart of any firm is its earnings. It is growth here that pushes its share price and dividend higher over time. So, the first quality I want in my passive income stocks is strong earnings potential.
I also want the yield to be high even before this earnings growth kicks in – over 7%, in fact. Why this figure? It is because I can currently receive around 4.6% from the risk-free rate (10-year UK government bonds). As recent market turbulence has underlined, stock investment is not risk-free, and I want compensation for taking that additional chance.
The final quality I look for in my passive income stocks is that they trade significantly under their ‘fair’ value. This reduces the chance of my making a loss on the share price if I decide to sell the stock.
A case in point from my portfolio
I think a prime example of these three qualities at work is British American Tobacco (LSE: BATS).
Analysts forecast the tobacco and nicotine replacement product firm’s earnings will increase 16% a year to end-2027.
The FTSE 100 heavyweight’s 2024 results showed adjusted organic revenue increasing 1.3% year on year to £25.867bn.
A risk here is that its move towards nicotine replacement products from tobacco ones fails for some reason. However, as of the 2024 figures, earnings per share also increased – by 3.6% to 136p – and the dividend rose 2% to 236p. This generates a current yield of 7.8%.
That said, analysts forecast the dividends will increase to 245.4p in 2025, 252.8p in 2026, and 264p in 2027. These will give respective yields of 8.1%, 8.3% and 8.7%.
A discounted cash flow analysis shows British American Tobacco shares are 54% undervalued at their current price of £30.29. So the fair value for them is technically £65.85, although market forces could push them lower or higher than that.
How much passive income could be made?
At the current 7.8% yield, 363 shares (£11,000-worth, the average UK savings amount) would make £858 in first-year dividends. On the same average yield this would rise to £8,580 after 10 years and to £25,740 after 30 years.
Crucially though, these returns would be much higher if dividend compounding were used. In this event and on the same average 7.8% yield, there would be £12,936 in dividends not £8,580. And after 30 years on the same basis, this would increase to £102,332 rather than £25,740.
By that time the total holding would be worth £113,332, which would be paying £8,840 a year in passive income, although of course this is not guaranteed!
But given this and the firm’s strong earnings growth prospects, I will buy more shares very soon.
