Passive income is money made with little effort, so it sounds too good to be true to some. Certainly, many of the methods claiming to generate such income look far from passive to me.
However, investing in shares that pay dividends is one way that has consistently fitted the bill in my experience.
Aside from selecting the shares and monitoring their progress occasionally, nothing much else needs to be done.
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Selecting the shares
British American Tobacco (LSE: BATS) is a good example of a great passive income stock, in my view.
First, it provides a very high annual yield that in turn generates a very high passive income. Specifically, it paid a total dividend of 230.89p in 2023, yielding 8.1% on the current share price of £28.36.
Second, a discounted cash flow analysis shows British American Tobacco to be 57% undervalued at its present price. So, a fair value for the stock would be £65.95, although it may go lower or higher than that.
In my experience, this underpricing decreases the chance of the passive income being wiped out by sustained share price losses. Conversely, it increases the likelihood of a share price rise over time, adding to the overall earnings from the stock.
Third, it has very strong earnings prospects. These are what drive a firm’s dividends (and share price) higher over time. Analysts forecast that British American Tobacco’s earnings will increase by a stunning 46.5% every year to the end of 2026.
They also expect its dividend yield to rise to 8.3%, 8.7%, and 9% in 2024, 2025, and 2026, respectively.
How much passive income can be made?
All firms have risks attached to them, of course, and this one is no different. A main risk for British American Tobacco is that its ongoing shift to nicotine substitute products will stall for some reason.
However, as it stands, £9,000 – the same amount I had when I started investing 30 years ago – can generate big dividends over time.
At the current 8.1% yield, this would generate £729 in dividends in the first year. Over 10 years on the same average yield it would be £7,290, and after 30 years, £21,870.
That said, much more could be made by buying more British American Tobacco shares using the dividends rather than spending the money.
The power of dividend compounding
Doing this (‘dividend compounding’) would make an extra £11,176 rather than £7,290, given the same average yield. Over 30 years on the same basis, an additional £92,399 would be generated, not £21,870.
With the initial £9,000 added, this would pay £8,213 a year in passive income, or £684 a month!
Assuming inflation over the period, the buying power of the money would be somewhat reduced by that time. There would also be some tax to pay, according to individual circumstances.
However, this clearly shows the size of annual passive income that can be made over time from much smaller investments. This is even more the case if those dividends are regularly used to buy more of the stock that paid them.
