Making money with minimal effort is the core of the passive income investment idea. And by far the best approach I’ve found to this is investing in shares that pay me dividends regularly.
Another quality I look for in a stock to add to my passive income portfolio is appearing undervalued against its peers. There are several methods of ascertaining this, but I prefer the price-to-earnings (P/E) and price-to-book (P/B) measurements.
These give me a broad indication of how much a stock is undervalued. I then try to nail it down further with a discounted cash flow analysis. After this, I look at whether it appears set for strong growth.
If it does, and the stock looks relatively undervalued to me, there’s less chance my dividend gains will be eradicated by big share price falls.
Is China’s growth engine firing up?
One stock I am seriously considering adding to my portfolio is Rio Tinto (LSE: RIO).
As a leading global commodities producer, it’s not had the best of times recently with uncertain growth prospects in China.
Since the mid-1990s, the country’s been the key global buyer of commodities to fuel its enormous economic growth. But that stalled during the Covid era, and the jury’s been out on when major growth will re-emerge.
I think we are now seeing signs of this resurgence. In 2023, it comfortably hit its target economic growth of “around 5%” — recording 5.2%. The same target’s been announced this year.
Several measures have been introduced to achieve this, and March’s key manufacturing data was the highest reading since May 2023.
The key risk in Rio Tinto shares is if China’s apparent economic recovery falters. Another is that the company fails to expand its sales in other key developing markets.
Having said that, even in last year’s depressed commodities market, it made a profit of $10bn. Underlying earnings were $12bn.
At the current share price of £51.84, the stock yields 6.6%, against the FTSE 100 average of 3.8%.
The share price looks very undervalued against its peers too — trading at a P/E of 10.1 against a peer group average of 37.1.
A discounted cash flow analysis shows it to be 50% undervalued. This implies a fair value of around £103.68, although it doesn’t necessarily mean the stock will ever reach that.
The dividend compounding miracle
If I invested £9,000 now in Rio Tinto shares that averaged a 6.6% annual yield, then 30 years from now I would have £64,832.This would pay me £4,130 in dividends every year, or £344 a month.
This is provided that rather than taking the dividends out and spending them, I reinvested them into the stock. This is known as ‘dividend compounding’.
However, on the same yield proviso, continuing to invest £5 a day (around £150 a month), would give me the same sized pot after just 14 years. After 30 years it would total £234,950, paying £14,913a year in dividends — or £1,243 a month.
Inflation would reduce the buying power of the income, of course. And there would be tax implications according to individual circumstances.
But it clearly shows that smaller investments in the right stocks can make much bigger returns over time if the dividends are reinvested.
