591 shares in this FTSE 100 high-yield gem could make me £14,873 a year in passive income over time!
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.
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Simon Watkins has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
