Dividends paid by shares are the truest form of passive income I have found to date. Generating these only involves picking the right shares in the first place and then occasionally monitoring their progress.
Many people do not do it because they believe it takes sizeable funds to start with. But this is not so. It can be done by saving and investing just a small amount each week, even from nothing in the bank.
How small? Around the cost of a pint of a lager, or a fancy coffee.
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Starting the investment journey
Putting aside that saved £5 a day is the beginning of this passive income generation process.
The next step is to select some high-quality stocks that deliver a high yield. I stuck to shares in the FTSE 100 when I began privately investing over 30 years ago. It is the most highly regulated UK index and it is easy to find information on its stocks.
My minimum requirement for my passive-income-focused stocks is a yield of 7%+. Why this number? Because I can make 4%+ from the 10-year UK government bond — known as the ‘risk-free rate’ — and stocks have risks.
I also look for undervalued shares. This reduces the chances of the dividends made being wiped out by price losses if I sell the stock.
And the final thing I want in my passive income holdings are businesses with good earnings growth potential. It is this that powers a share’s dividend and price higher over time.
One of my top passive income holdings
A stock I regard as a prime example of these qualities – and which I hold — is Phoenix Group Holdings (LSE: PHNX).
It is a FTSE 100 firm with one of the highest yields in the index – currently 10.2%. By contrast, the leading index’s average yield is just 3.6%.
Additionally, its price-to-sales (P/S) ratio of 0.2 looks very undervalued against its peers’ average of 1.3. Indeed, a discounted cash flow analysis shows the stock is 17% undervalued at its current £5.14 price. So a fair value for the shares is £6.19, although they could trade lower or higher, given market vagaries.
And finally on earnings growth, consensus analysts’ forecasts are that these will rise a stellar 76.7% each year to end-2026.
A risk here is the high degree of competition in the financial sector, which may squeeze its profit margins.
Building up passive income
Investors considering saving and investing £5 a day (£150 a month) in Phoenix Group shares at an average 10.2% yield would make £13,345 in dividends after 10 years.
This would rise to £302,894 after 30 years on two provisos. First, that the yield averages the same over the period (which is not guaranteed). And second, that the dividends are compounded.
By that time, the shares would be generating £30,895 in passive income each year, or £2,575 a month!
Assuming inflation over the period, the buying power of this money would have diminished somewhat. However, it shows an individual can make high dividend income from relatively small regular savings and investments, even starting with no money in the bank.
