Passive income is money made from minimal effort. And by far the best way I have found of doing this is investing in shares that pay dividends.
This only involves selecting high-quality stocks that pay high dividends and occasionally monitoring their progress.
The dividends are generated regardless of whatever else I do, including sleeping. And if they are reinvested back into whichever stock paid them, they can make for a much better life and retirement.
This process is called ‘dividend compounding’ and is similar to allowing interest to grow in a bank account.
A case in point
One of the stocks I bought precisely for this purpose is Imperial Brands (LSE: IMB). In 2024, it paid a dividend of 153.42p, which yields 6% on the current £25.73 share price.
So, investors considering an investment of £11,000 (the average UK savings amount) would make £660 in first-year dividends. Over 10 years on the same average yield, this would rise to £6,600 and over 30 years to £19,800.
However, using the dividend compounding method would turbocharge these dividend payouts. Doing this on the same 6% average yield would make £9,013 after 10 years, not £6,600. And after 30 years on the same basis, the dividend payments would be £55,248, rather than £19,800.
With the £11,000 initial investment added in, the Imperial Brands holding would be worth £66,248 by then. And this would be generating £3,975 in annual passive income from dividends by that stage.
That said, the yield can go up or down. Analysts forecast that Imperial Brand’s dividend will rise to 164p in 2025, 171.4p in 2026, and 176.2p in 2027. This would generate respective yields of 6.4%, 6.7% and 6.8%.
A profit to be had on the share price too?
I do not intend to sell any of the shares I own that are geared to generating passive income. However, it is good to know if I ever did they would not make a loss from the price at which I bought them.
Therefore, I only ever buy shares that look very undervalued to me and this applies to Imperial Brands. Right now, a discounted cash flow analysis shows the shares are 63% undervalued at their current price of £25.73. So, a fair value for them is £69.54, although market unpredictability could push them lower.
Such an undervaluation reduces the chance of a loss being made on the share price, in my experience.
How does the business look?
A key risk to Imperial Brands’ profit margins in my view is the high degree of competition in its sector.
Nonetheless, its full-year 2024 results released on 19 November saw adjusted operating profit rising 4.6% year on year to £3.9bn. This beat consensus analysts’ forecasts of a 4.3% increase.
Net revenue from its next-generation products (including nicotine replacements and vapes) soared 26%. And adjusted earnings per share rose 10.9%, driven by profit growth and share count reduction from buybacks.
Looking ahead, the firm forecasts operating profit growth next year in the mid-single-digit percentage area.
If I did not already have a sizeable holding in the firm, I would buy the shares today for their excellent passive income potential.
