Legendary investor Warren Buffet has best encapsulated the idea of passive income. 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 by investing in shares that pay me dividends.
As I am reducing my working commitments having turned 50 a while back, the higher the dividends the better.
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But I also look for a strongly growing company to support high dividend payments into the future.
I recently added to my holding in British American Tobacco (LSE: BATS), based on these key factors.
High yield with a turbo boost
The company has a notable history of paying high yields. Aside from the current 9.8% it pays, the yields in 2022, 2021, and 2020 were 6.7%, 7.9%, and 7.8%, respectively.
It is now one of the very few shares in the leading FTSE 100 index that pays an annual return of over 9%. By comparison, the average current yield of the leading index is 3.8%.
So £11,000 – the average savings amount in the UK – invested at 9.8% would make £1,078 this year in dividends payments.
If the yield averaged the same over 10 years, the dividends would be £10,780 on top of the £11,000 investment.
Crucially however, these returns could be turbo-boosted by reinvesting the dividends paid back into the stock.
This is known as ‘dividend compounding’ and is the same process as compound interest in a bank account. But rather than interest being reinvested, dividend payments are.
If this was done, then the dividend payments after 10 years would total £18,193 instead of £10,780!
This would mean £29,193 in total, paying £2,715 a year in dividends, or £226 a month.
Over 30 years on an average 9.8% yield, the investment pot would total £205,605, paying £19,119 a year, or £1,593 a month!
Inflation would reduce the buying power of the income, of course. And there would be tax implications according to individual circumstances. Plus, dividends might be cut.
However, it highlights that a significant passive income can be generated from relatively small investments in the right stocks if the dividends are reinvested.
Is the high yield sustainable?
A company’s earnings and profits drive dividend payouts over the long term. If these decline, then dividends are likely to fall as well.
There are risks in British American Tobacco’s case, of course, as in all stocks. One is that its ongoing transition away from tobacco products to nicotine substitutes is delayed for some reason. Another is any litigation from the effects of its products in the past.
However, the company’s adjusted profit from operations in 2023 rose 3.1% from 2022 to reach £12.47bn. Adjusted diluted earnings per share (EPS) increased 4% over the same period to 375.6p. And adjusted net debt fell 7.4% to £33.94bn.
Consensus analysts’ estimates are that it will grow earnings by 49.4% every year to the end of 2026. Earnings per share are expected to grow by 47.8% each year to that point. And return on equity is forecast to be 16.4% by then.
Given its very high yield and strong business outlook, British American Tobacco remains a key stock in my passive income portfolio.
