Investing in high-quality, high-yield shares is the best way I have found to date of making passive income.
For a start, it does not involve much effort — hence the ‘passive’ label. The only activity required is picking the shares, monitoring their progress, and making the occasional adjustment to the holdings.
Additionally, the dividends paid by the shares are real, regular, and not subject to unexpected costs. Unlike some other ways of making passive income, dividends are not just paper gains – they go directly into a person’s bank or investment account.
And they do so on predetermined dates regularly. The only costs associated with them are standard taxes, according to individual circumstances.
In short, investing in FTSE-listed dividend-paying stocks is clear, transparent, devoid of genuine hassle, and highly rewarding, in my experience.
A prime passive income share?
For me, any prime passive income stock requires a much higher yield than the FTSE 100’s 3.7% average or the FTSE 250’s 3.3%.
British American Tobacco (LSE: BATS), for example, currently yields 8.1%. Analysts estimate this will rise to 8.4% by the end of this year, to 8.8% in 2025, and 9.2% in 2026.
As dividends are driven by rising company earnings, any passive income share also needs good growth prospects, in my view.
A risk here is the very competitive tobacco and nicotine replacement market. Another is major slippage in the firm’s ongoing switch from the former to the latter. However, analysts forecast that British American Tobacco’s earnings will grow 49% by end-2026.
Finally, in order that the passive income is not erased by extended share price losses, I look for undervalued stocks.
A discounted cash flow analysis shows British American Tobacco to be 57% undervalued at its present price of £28.50. Therefore, a fair value would be £66.28, although it could go lower or higher than that.
Passive income generation
£10,000, as an example, would make £810 in the first year, based on British American Tobacco’s 8.1% yield.
Over 10 years on the same payout, this would increase to £8,100, of course, and over 30 years to £24,300.
It is a better return than could be had from a standard UK savings account for sure. However, using the dividends to buy more British American Tobacco shares could generate much, much more.
This is known as ‘dividend compounding’ and is the same process as leaving interest in a bank account to accumulate.
Supercharging passive income returns
Doing this on the same average yield would generate an extra £12,418 after 10 years, rather than £8,100. After 30 years, an additional £102,665 would have been made, instead of £24,300.
Adding in the initial £10,000 would give a total investment value of £112,665. And this would pay an annual passive income at that point of £9,126, or a monthly £761!
Inflation would reduce the buying power of the income over time, of course. There would also be tax implications.
However, the figures highlight what big passive income can be made from much smaller investments, especially if the dividends are reinvested.
This post was originally published on Motley Fool
