I look for three key qualities in my ‘passive income’ stocks. This is money made with little effort on my part, aside from selecting the shares in the first place.
The first of these is a high dividend yield. This will vary as a stock’s price moves, provided the annual dividend stays constant. But it will also change if that yearly payout alters.
My minimum dividend yield requirement when I buy such a stock is 7%. This is because I get 4.5% from the ‘risk-free rate’ (the UK 10-year government bond), and shares have added risk. It is my compensation for taking that additional chance.
Undervaluation
The second characteristic I want is that these passive income stocks appear at least 30% underpriced to their ‘fair value’. This value is based on discounted cash flow (DCF) analysis, itself derived from cash flow forecasts for an underlying business.
Being undervalued reduces the chance of my making a loss on the share price that would negate some of my dividend gains. Conversely, it increases the chance of my making a profit on the same.
Anything less than 30% could be nullified by high market volatility, in my experience as a former senior investment bank trader.
Earnings growth
The third and final facet I look for is a firm’s earning growth potential. It is this ultimately that drives any firm’s stock price and dividends over the long term.
Clearly, the higher the better here for me, although I look for at least 6% a year. This once more reflects the risk-free rate plus a little on top for a modicum of management skill in running a business.
Otherwise, a firm might equally well sell all its assets currently and invest the proceeds in 10-year UK government bonds.
A case in point
British American Tobacco (LSE: BATS) paid a total dividend of 235.5p in 2024. This currently generates a yield on the current £34.61 share price of 6.8%.
That said, analysts forecast the dividend will rise to 245.6p this year, 249.2p next year, and 258.4p in 2027. Based on the current share price, this would generate respective dividend yields of 7.1%, 7.2%, and 7.5%.
On the share price, the DCF using other analysts’ figures and my own shows it is 44% undervalued. Therefore, its fair value is £61.80.
And its earnings are forecast to increase 16.3% every year to the end of 2027. A risk to monitor here is whether the intense competition in the sector squeezes it margins.
How much passive income can be made?
Using only the current 6.8% yield, investors considering a holding of £11,000 (the average UK savings) in the firm would make £10,671 in dividend after 10 years. On the same average yield – with no forecast rises and no falls factored in – this would increase to £73,111 after 30 years.
Both figures are based on the dividends being reinvested back into the stock – ‘dividend compounding’.
Adding in the initial £11,000 and the value of the holding would be £84,111 by then. It would pay £5,720 a year in passive income by that point. But none of this is guaranteed, of course.
Given its earnings growth potential, share price undervaluation, and high yield I think it is time for me to buy more of the shares very soon.
