Passive income is money made with minimal daily effort by the investor. And as Warren Buffett said: “If you don’t find a way to make money while you sleep, you will work until you die.”
The best way I’ve found to make money while I sleep is to buy high-dividend-paying shares. The earlier this begins, the better, in my view. This allows for the flattening out of any short-term shocks seen in the markets.
It also enables bigger returns to be made through ‘dividend compounding’. This is the same principle as compound interest in bank accounts, but rather than interest being reinvested, dividend payments are.
Selecting the stocks
The FTSE 100 index has many high-quality stocks that pay high dividends.
In addition to this quality, I also look for stocks that appear undervalued compared to their peers. I use several stock valuation metrics for this, with the most important for me being price-to-earnings, price-to-book, and discounted cash flow.
The reason for this is that I want to minimise the chance that my dividend gains are diminished by share price losses.
After this, I look at how strong the underlying business appears to ascertain if it’s on a sustainable uptrend. This includes examining short-term and long-term asset and liability ratios, new business initiatives, and senior management capabilities, among other factors.
Case study
My core portfolio geared to generating high passive income consists of six stocks all chosen according to the above three criteria.
These are Phoenix Group Holdings, British American Tobacco, Imperial Brands, M&G (LSE: MNG), Legal & General, and Aviva.
I recently added to my holding of M&G, so it’s a good case in point for my passive income strategy in action, I think.
I bought more shares after what looked to me to be strong 2023 results, so that’s the business box ticked.
These showed a 28% rise in adjusted operating profit from 2022 to £797m. It forecasts a £2.5bn three-year operating capital generation target by the end of this year. And it expects £1bn-£1.5bn of additional sales each year from the booming bulk annuity market it re-entered last year.
There are risks in the stock, of course, as in all stocks. One is a new global financial crisis. Another is its relatively high debt-to-equity ratio of around 1.9.
This said, analysts’ expectations now are for earnings to grow 20% a year to the end of 2026.
A discounted cash flow analysis also shows M&G shares to be around 49% undervalued at the current price of £2.20. Therefore, a fair value would be around £4.31, although it may never reach that point, of course.
So, that’s the valuation box ticked for me.
Big passive income payer
The high-dividend box is also ticked, with M&G currently paying 8.95% a year.
So, £20,000 invested now — with the yield averaging the same and the dividends reinvested – would give me £290,258 after 30 years.This would pay me £24,761 a year, or £2,063 a month in passive income!
Inflation would also reduce the buying power of the income, of course. And there would be tax implications according to individual circumstances. But the figures underline what can be achieved.
