£10,000 in savings? Here’s a smart way for investors to target £2,853 in yearly passive income from a FTSE 100 dividend star…

British American Tobacco (LSE: BATS) has been a holding in my core passive income portfolio for several years. ‘Passive’ income is money made with minimal effort from me, which is the sort of work-reward ratio I like.

Indeed, the only real exertion on my part is choosing the shares in the first place. After that, it is just a case of monitoring their performance regularly and making changes if necessary.

The portfolio is geared to generating sufficient dividend income for me to continue to reduce my working commitments. I could always draw down some of these dividends to finance anything else that I wanted beforehand, of course.

A good dividend yield

When I first bought British American Tobacco shares, the yield was well above 7%. This is generally my minimum, as I can get 4.5% from the ‘risk-free rate’ (this rate is the yield on the 10-year UK government bond) and shares are not risk-free.

However, a stock’s dividend yield moves in the opposite direction to its price, provided the annual dividend stays the same. As British American Tobacco’s price has risen considerably in recent months, its dividend yield is down to 5.5% now.

That said, analysts forecast that its dividends will rise to 244.3p this year, 248.9p next year, and 256.9p in 2027.

This would generate respective dividend yields on the current share price of 5.7%, 5.8%, and 6%.

Share price potential

Aside from a good dividend yield, another important factor for my passive income stocks is an undervalued share price. This reduces the chance of a price loss eating into my dividend returns. Conversely, it increases the chance of my making a profit should I sell the stock.

That said, despite British American Tobacco’s recent price gains I think the stock is still very undervalued.

In fact, a discounted cash flow (DCF) valuation shows it is 40% undervalued at its current £43.17 price. A DCF identifies where any firm’s share price should be, derived from cash flow forecasts for the underlying business.

Therefore, the stock’s fair value is £71.95. My experience as a senior investment bank trader and longtime private investor tells me that assets will tend to converge to their fair value over time, although this is not guaranteed.

Passive income generation potential

Investors considering a £10,000 holding in 5.5%-yielding British American Tobacco would make £7,311 in dividends after 10 years.

This is based on the dividends being reinvested back into the stock – known as ‘dividend compounding’.

Using the same standard investment practice, the dividends would rise to £41,874 after 30 years.

Including the initial £10,000, the holding would be worth £51,874 by that time. And this would generate £2,853 a year in passive dividend income by that point!

Will I buy more of the stock?

Ultimately what drives any firm’s share price and dividends over time is earnings growth. A risk to British American Tobacco’s is the intense competition in its sector.

However, consensus analysts’ estimates are that its earnings will increase by 17% every year to end-2027.

Given this, the extreme undervaluation, and rising dividend yield forecasts, I will buy more of the shares very soon.

The post £10,000 in savings? Here’s a smart way for investors to target £2,853 in yearly passive income from a FTSE 100 dividend star… appeared first on The Motley Fool UK.

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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.