Dividends paid by shares are the best way I have found to generate passive income. This is money made with little ongoing effort and can make life a lot more fun in the short term. It can do the same over the long term too and might also enable investors to retire early if they wish.
I have been steadily building up my passive income portfolio for many years. And experience has shown me that three qualities in particular make for a great income share.
The first is earnings growth potential. Consistent increases here are what drive any company’s dividend – and share price – higher over the long term.
The second is a high initial yield that is forecast to rise. These strong dividends when reinvested back into the stock that paid them – ‘dividend compounding’ — can produce tremendous annual passive income over long periods.
And the third is a valuation gap between the purchase price of a stock and its fair value. This increases the chance of a profit being made on the share price if an investor wants to liquidate it.#
A prime example from my portfolio
Legal & General (LSE: LGEN) has long been one of my core passive income holdings and exhibits all three qualities.
On the first, analysts forecast its earnings growth will be a stunning 28% a year to the end of 2027 as a minimum. A risk to these is the intense competition in the financial sector.
That said, the firm paid a dividend of 21.36p in 2024, giving a yield of 9% on the current £2.38 share price. Analysts project that the dividends will rise to 21.8p in 2025, 22.3p in 2026, and 22.6p in 2027.
These would give respective yields on the current share price of 9.2%, 9.4%, and 9.5%. So, this is the second of my key passive income stock criteria fulfilled.
And finally, the stock also looks extremely undervalued to me based on its future cash flow forecasts. Using other analysts’ figures and my own, the resulting discounted cash flow analysis shows it is 59% undervalued at its current price of £2.38.
Therefore, the fair value for the shares is £5.80, although market unpredictability could move them lower or higher.
A passive income powerhouse
Investors considering a holding of £11,000 – the average UK savings – in Legal & General would make £990 in first-year dividends.
On the same 9% average yield this would increase to £9,900 after 10 years and to £29,700 after 30 years.
This is a lot more than could be made from a standard UK savings account, of course, if less safe than such an account. But using dividend compounding would generate far greater returns.
Doing this on the same average 9% yield would generate £15,965 in dividends after 10 years not £9,900. And after 30 years on the same basis this would have increased to £151,036 rather than £29,700.
Will I buy more of the shares?
Given their strong earnings growth prospects, I am always on the lookout to buy the shares on a dip. Currently they are down 10% from their 7 February 12-month traded high of £2.65, so that fits the bill nicely.
As I believe the strong earnings growth will power the share price and dividends higher, I will buy more of the shares as soon as possible.
