My investment focus in recent years has been on maximising passive income from dividends paid by shares. This is the best way I have found to make money with minimal effort – the definition of passive income.
British American Tobacco (LSE: BATS) has long been one of my core holdings for achieving this. It has all three qualities that I look for in such a stock — a high yield, strong earnings growth, and market undervaluation, in my view.
A high yield
In 2023, it paid a total dividend of 230.89p, yielding 8% on its current £28.76 share price.
This year, it lifted its three interim dividends by 2%. If the final interim dividend increased by the same amount the total payout would be 235.2p. This would yield 8.2% compared to the average 3.6% of the FTSE 100.
Analysts forecast dividends of 246.5p in 2025 and 257.9p in 2026, giving respective returns of 8.6% and 9%.
Strong earnings growth
Ultimately, earnings growth drives a firm’s dividend and share price. A risk to this for British American Tobacco is any delay in its switch from tobacco products to nicotine replacements, I think. This could give competitors doing the same thing a market advantage.
However, as it stands, analysts forecast that its earnings will increase by a stunning 44% each year to end-2026.
Share undervaluation
I have no intention of selling the shares, provided they keep generating a high yield. However, should I ever need to do so, I would obviously rather not make a loss on what I paid for them.
To minimise the chance of this happening, I only buy shares that are undervalued on two broad measures. First, against the shares of competitor firms, based on key ratios I use. And second, on the price indicated by using future cash flow forecasts for the firm.
On the former, British American Tobacco is undervalued on both the price-to-book and price-to-sales ratios.
On the latter, a discounted cash flow analysis shows the stock is 57% undervalued at £28.76. Therefore, a fair value would be £66.88, although it might go lower or higher, given market unpredictability.
How much passive income can be made?
£17,000 (the average UK savings account amount) would buy me 591 shares in the firm now. And if I currently had the ready funds available to do this, I would do it right now.
With an 8% yield, these would pay £1,360 in dividends in the first year. This would rise to £13,600 after 10 years on the same basis and to £40,800 after 30 years.
However, by using the dividends to buy more British American Tobacco shares, these payouts would rise enormously.
Doing this (‘dividend compounding’) on an 8% yield would generate £20,734 of dividends after 10 years, not £13,600. And after 30 years, the dividends paid would rise to £168,907 instead of £40,800.
The total value of the holding (adding in the £17,000 initial investment) would be £185,907. Consequently, if the stock were still yielding 8% (it could be lower or higher), it would generate £14,873 a year in passive income by then.
Inflation would reduce the buying power of the money over the period. However, it shows a small investment can generate big passive income, especially when dividends are compounded.
This post was originally published on Motley Fool
