After a 10% drop in this FTSE gem, investors could target £6,250 in yearly passive income from an £11,000 stake!

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.

The post After a 10% drop in this FTSE gem, investors could target £6,250 in yearly passive income from an £11,000 stake! appeared first on The Motley Fool UK.

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Simon Watkins has positions in Aviva Plc. The Motley Fool UK has no position in any of the shares mentioned. 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.