If I were looking for £1,000 per year in pasive income, I’d buy shares in Diploma (LSE:DPLM). The FTSE 250 stock isn’t an obvious choice, with a dividend yield of just 1.95%.
That’s lower than the inerest rate I could get from a savings account right now. But over the long term, I think that Diploma shares could be a great investment.
Investment returns
At today’s prices, I’d need 1,858 Diploma shares for £1,000 in passive income. That would require an initial investment of just over £51,700.
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That’s a lot of money to put into one stock and I’m not in a position to do it right now. But I would expect the stock to generate much more than £1,000 per year going forward.
Over the last five years, Diploma has been growing its dividend at a rate of 16.5% per year. If it keeps doing this in the future, then the potential returns for investors could be huge.
After five years of 16.5% annual growth, an investment of £51,700 would be paying out £1,900 per year in dividends. That’s almost twice as much as the current yield.
The potential returns get even more attractive looking ahead. With the same growth rate, my annual pasive income would be £4,400 after 10 years, £9,900 after 15 years, and £22,700 after 20 years.
In other words, Diploma might not be an obvious choice for passive income right now. But it’s one that can pay big dividends if it can maintain its current growth rate.
Growth
The big question is how long the company can keep growing its dividend at 16.5% per year. Dividend income is never guaranteed, but I think there’s reason for optimism here.
Diploma is a collection of smaller businesses. That means that it tries to grow its earnings in two ways — by earning more with its existing businesses, or by acquiring new ones.
The company’s impressive growth recently has been the result of its acquisitions. Moving forward, I expect acquisitions to account for more and more of Diploma’s growth.
With this type of business, there’s always a risk of impairing the balance sheet by paying too much for an acquisition. But there are two main reasons that I think this is unlikely to be a problem for Diploma.
The first is that Diploma is still a fairly small company. Warren Buffett notes that Berkshire Hathaway’s size makes it difficult to find acquisitions big enough to help the company grow.
Diploma is around 0.5% of Berkshire’s size. That gives it a much bigger set of opportunities when it comes to making acquisitions.
The second is that the company’s management has a good record of making disciplined acquisitions. And that has continued in 2022.
In the first half of the year, Diploma acquired three businesses paying an average of less than 10 times earnings. For context, its own stock trades at an earnings multiple of around 25.
Dividend growth
Diploma’s dividend doesn’t immedaitely jump out as attractive. But I think that the company’s growth prospects mean it could generate huge returns in the future.
I own Diploma shares in my Stocks and Shares ISA, and I’m looking to add to my investment in the near future.
