Passive income is money made with little effort on the part of the recipient. The best example of this in action that I have found over the years is the dividends paid by shares.
FTSE 100 housebuilder Taylor Wimpey (LSE: TW) has been a generous provider of dividends for many years. Over the past 12 months though, the 41% slide in its share price has pushed the dividend yield to nearly 10%. This is because a share’s price and its yield move in opposite directions, provided the annual dividend remains the same.
Ten per cent is the golden annual return level, as it means the money invested is doubled over 10 years. In fact, it can more than double if the dividends are reinvested back into the stock that paid them. This is a standard investment practice known as ‘dividend compounding’.
Huge income potential
More specifically in Taylor Wimpey’s case, it paid a dividend in 2024 of 9.46p. This generates a current dividend yield on the present 96p share price of 9.9%.
This is one of the highest such payouts in any of the leading FTSE indexes. By comparison, the current average dividend yield of the FTSE 100 is just 3.4%. And on the FTSE 250 it is only 3.3%. It is also more than double the ‘risk-free rate’ (the 10-year UK government bond) of 4.7%.
Without dividend compounding being used, £10,000 invested in Taylor Wimpey would make £990 in first-year dividends. After 10 years on the same 9.9% yield, this would rise to £9,900 and after 30 years to £29,700.
Impressive returns certainly, but they could be much more with dividend compounding employed.
In this case, the dividends would be £16,803, not £9,900. And after 30 years they would rise to £182,559 rather than £29,700.
At that point, including the £10,000 initial investment, the value of the Taylor Wimpey holding would be £192,559. And this would generate a yearly passive income of £18,073!
How does the core business look?
It is a firm’s earnings that ultimately drive its ability to keep paying high dividends. They are also the key to increases in a stock’s price over time.
A risk to Taylor Wimpey’s is a renewed surge in the cost of living if inflation continues to rise. This could deter people from moving home.
Indeed, this has been one of the reasons behind the firm’s share price slide this year. Another more recent factor was the 30 July cut in its operating profit forecast to £424m from £444m.
However, I think the price reaction to the latter factor was overdone. The £20m difference arose solely from remediation work at one of its developments caused by defective contractor work.
Overall, Taylor Wimpey reiterated guidance of 10,400-10,800 UK completions range this year compared to 9,972 in 2024.
Moreover, consensus analysts’ forecasts are that Taylor Wimpey’s earnings will grow by a stellar 34.9% a year to end-2027.
My investment view
I never like to buy stocks priced below £1, due to increased price volatility risks.
However, a discounted cash flow analysis shows the stock is 74% undervalued at its present 96p price. Therefore, its fair value is £3.69.
Given this, its very high dividend yield, and its superb earnings growth prospects, I will buy the stock very soon.
