Dividends paid by shares are the best way I have yet found to generate high passive income over time. This is money made with minimal effort, and in this case it is focused on choosing good stocks in the first place. After that, the only energy really expended by me is to monitor how they are performing every now and again.
One of my core passive income holdings has dipped in price recently, which I am using as an opportunity to buy more. So, how much could I make here?
7%+ yield?
UK housebuilder Taylor Wimpey’s (LSE: TW) current dividend yield is 9%. This is nearly treble the present FTSE 100 average of 3.1% and sits well above my 7%+ minimum criterion. This is important to me because it effectively provides compensation for taking the risk of investing in shares over no risk at all. And no risk at all is represented in the ‘risk-free rate’ — which is the 10-year UK gilt yield. This is currently 4.8%.
Of course, yields can go up and down over time. In Taylor Wimpey’s case, analysts forecast it will rise to 9.2% over the medium term.
However, a £20,000 holding in the firm (the same as mine) at the current 9% rate as an average would make £29,027 in dividends after 10 years. This also assumes the dividends are reinvested back into the stock to harness the enormous power of dividend compounding.
On the same basis, the dividends would increase to £274,612after 30 years. At that point, the holding’s total would be £294,612.
And this would pay £26,515 a year in income from dividends alone!
Deeply underpriced to ‘fair value’?
Price is simply whatever the market will pay at any moment, but value reflects the fundamentals of the underlying business.
The difference between the two is crucial for the profits of long-term investors. This is because share prices tend to converge to their fair value over the long run.
Discounted cash flow analysis identifies where any stock should trade by projecting future cash flows and discounting them back to today.
Analysts’ DCF modelling varies depending on assumptions used — some more bullish than mine, others more bearish. However, based on my DCF assumptions — including an 8.3% discount rate — Taylor Wimpey shares could be as much as 51% undervalued at their current 85p price.
This implies a fair value for the shares of around £1.73 — more than double where it trades today.
Strong forecast earnings growth?
Earnings growth in a firm is vital for sustained long-term gains in both dividends and share price. A risk for Taylor Wimpey is a further surge in the cost of living that may deter people from moving home. Another is any rise in interest rates that could increase the cost of its borrowing.
Nevertheless, the consensus forecast of analysts is that its earnings will grow a whopping average of 23.9% every year over the medium term.
Given the strength of this business engine, I think the share price will move close to its fair value and the firm’s dividends will rise.
As such, I will buy more of the stock at the earliest opportunity. And I also have my eye on other dirt-cheap, high-yield stocks with high forecast earnings growth as well.
