I am a big fan of passive income for two key reasons.
First, it can generate life-changing flows of money that make everyday life better and can enable early retirement.
And second, it involves minimal regular effort – just choosing the right stocks in the first place and monitoring their progress.
A 7%+ yield requirement
One of three key qualities in my passive income stocks is a high dividend yield. This can change when a firm’s share price and/or annual dividend alters.
Nevertheless, I want a yield of over 7% at the point of selecting a stock.
This is because the 10-year UK government bond – the ‘risk-free rate’ — yields 4%+ and shares have risks attached.
The 20%+ undervaluation criterion
The second thing I want in my passive income stocks is that they look significantly undervalued.
The minimum I look for is a 20% under-pricing to their ‘fair value’. I believe anything less could be due to short-term market volatility rather than to a structural undervaluation of a firm.
For me, two sets of data determine whether any stock is undervalued at its current price. These are a firm’s key share measurements compared to its competitors and future cash flow forecasts for it.
Buying stocks that appear undervalued reduces the chances of me losing money on the price if I sell it. Conversely, it increases the possibility that I will make money in this event.
The 10%+ earnings growth preference
Earnings growth ultimately powers a company’s dividend and share price over the long term.
I will never buy a stock for my passive income portfolio that is forecast to see its earnings decline.
As a rule of thumb, I want to see annual earnings growth of at least 10%. If consistently delivered, this should drive a significant increase in a firm’s share price and dividend, in my experience.
An example from my portfolio
FTSE 100 insurance and investment giant Aviva (LSE: AV) currently yields 7% — right on my 7%+ requirement.
However, analysts forecast its dividend will rise to 37.9p in 2025, 40.7p in 2026, and 43.9p in 2027.
These would give respective yields on the current £5.11 share price of 7.4%, 8%, and 8.6%.
Additionally, a discounted cash flow analysis using other analysts’ numbers and my own show its shares are 55% undervalued. So their fair value is £11.36, although market unpredictability could move them lower or higher.
And finally, consensus analysts’ projections are that the firm’s earnings will grow 14.2% each year to end-2027.
Long-term risks to these are the intense competition in the sector, in my view.
Passive income returns
Investors considering a stake of £11,000 (the UK average savings amount) in Aviva would make £11,106 in dividends after 10 years. This would increase after 30 years to £78,281.
It should be noted here that these figures are based on the same average 7% yield over the periods.
It also factors in that the dividends are reinvested back into the stock every year – called ‘dividend compounding’.
Including the initial £11,000 and the value of the holding would be £89,281. This would pay £6,250 a year in passive income by that point.
Given its strong earnings growth forecasts, undervalued share price and high yield, I will buy more Aviva shares shortly.
This post was originally published on Motley Fool
