Passive income is money made from doing very little, if anything, on a daily basis. Consequently, I’m a big fan, as is legendary investor Warren Buffett. He said: “If you don’t find a way to make money while you sleep, you will work until you die.”
I’ve tried a few passive income ideas in the past, most notably buy-to-let. As I started in London with a property I’d bought years before, it made me a lot of money. But it also occupied a lot of my time dealing with things I wasn’t interested in.
I then fully switched over to buying shares that paid me high dividends. They also had to look set for strong growth and be undervalued against their peers.
Crucially for me, once I’ve picked the stocks, all I need do is check they’re performing as they should.
A case in point
I added FTSE 100 heavyweight Imperial Brands (LSE: IMB) to my high-yield portfolio recently. On its current share price of £18.22, its 2023 dividend of 146.82p a share yields 8.1%.
Like other tobacco firms, it’s very out of vogue, so also trades at a very cheap valuation against its peers.
On the key price-to-earnings (P/E) stock valuation measurement, it’s at just 6.5. This compares to a peer group average of 14.2, so it’s a bargain as far as I’m concerned.
How much of a bargain is revealed by a discounted cash flow analysis showing it to be around 65% undervalued right now.
Its fair value, then, is around £52.06, although this is no guarantee it will reach that price.
Business-wise, the firm is transitioning away from tobacco products to nicotine ones, which is a good move in my view.
The change appears to be going well, with 2023 profits increasing 26.8% over the previous year — to £3.4bn. Its nicotine replacement goods saw net revenue up 26% over the same period.
A risk in the stock is that this transition falters, allowing its competitors to gain market share at its expense. Another is future legal action for health problems caused by its products in the past.
That said, analysts’ forecasts now are for earnings per share to grow by 5.2% a year to the end of 2026. Return on equity is projected to be 53% by that time.
Reinvesting dividends is vital
If I invested £9,000 in Imperial Brands – averaging an 8.1% yield – then I’d have another £7,290 after 10 years. This is if I just took the dividend payments out each year and spent them on something else.
But if I reinvested them to buy more stock then I’d have made another £11,176 instead in dividend payments.
This process is called ‘dividend compounding’ in the investment business. It’s the same idea as compound interest in bank accounts but instead of interest being reinvested, dividend payments are.
After 30 years of doing the same, provided the yield averages 8.1%, I’d have £101,399. This would pay me £7,864 a year in dividends or £655 each month!
Inflation would reduce the buying power of the income, of course. And there would be tax implications according to individual circumstances.
However, it highlights that a significant passive income can be generated from relatively small investments in the right stocks if the dividends are reinvested.
