Legendary investor Warren Buffett best encapsulated the key idea at the heart of passive income, in my view. 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 making money while I sleep is through dividends paid by shares. The only real effort on my part is to choose good stocks initially and then to monitor their progress periodically.
One share that caught my eye recently is terrestrial and digital media giant ITV (LSE: ITV).
Why this one?
For a start, the firm delivers a current dividend yield of 6.5% — way higher than the FTSE 100’s 3.1% or the FTSE 250’s 3.4%.
Better still is that analysts forecast this will rise to 7% by 2028.
So, investors considering a £20,000 holding would make £20,193 in dividends after 10 years and £142,330 after 30 years. This period is commonly seen as a standard investment cycle for long-term investors.
The numbers assume the same 7% forecast yield as an average, although this can go up and down. It also factors in the dividends being reinvested back into the stock to capture the turbocharging effect of ‘dividend compounding’. It is like allowing interest to grow in a savings account.
At the end of 30 years, the holding would be worth £162,330 (including the original £20,000 investment). And this would pay £11,363 every year in income from dividends.
A share price bonus too?
On top of that potential income stream, I think there could be share price profits too. This is because the current price of ITV is far below the ‘fair value’ of the stock. And over time, asset prices (including shares) tend to converge to this true value.
Discounted cash flow (DCF) analysis enables investors to pinpoint the price at which any stock should trade. It does this by projecting future cash flows for the underlying business and ‘discounting’ them back to today.
Some analysts’ DCF modelling is more bearish than mine, depending on the data used. However, based on my DCF assumptions — including an 8.2% discount rate — Vodafone shares are 27% undervalued at their current 77p price.
This implies a ‘fair value’ of around £1.05.
Given the gap here to its current price, this suggests a potentially terrific buying opportunity to consider today if those DCF assumptions hold.
My investment view
A risk here, in my view, is the sub-£1 share price, which adds price volatility to the value proposition. Aged over 50, I am in the latter part of my 30-year investment cycle and am looking to minimise risk. Another risk is the intense competition in its sector that may squeeze its margins.
However, for those younger than I or with less risk aversion, I think ITV looks a strong passive income play. It is starting from a high dividend yield base, and this is projected to rise to the key 7% level.
Why is this key for me? Because it effectively offers compensation for taking the additional risk in share investment over no risk at all. And the ‘risk-free rate’ (the 10-year UK gilt yield) is currently 4.8%.
Meanwhile, other high-yielding, deeply discounted shares have caught my eye in the last few days.
