Stock market

£20,000 in savings? Here’s how I’d like to turn that into £16,075 a year of second income.

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A second income gives anyone more options in life, so the more the merrier as far as I’m concerned. And if it can be done on a daily basis with little effort, even better.

The best way I have found to achieve this is to invest in stocks that pay high dividends. After choosing the right stocks, the only next task is to make sure they are performing as they should.

Stock selection

I recently increased my holding. Imperial Brands (LSE: IMB), so this is a good example of my process.

First, of course, every stock needs to pay at least a 7% yield. Why 7%? Because I can get 4%+ risk free from a 10 year UK government bond, and stocks are not risk free.

Imperial Brands paid a dividend of 146.82pa a share in 2023. At the current £18.69 share price, that gives it a yield of 7.9%.

Second, a stock needs to look set for strong growth. Earnings drive dividend payments, so if the former increases over time, so will the latter.

For Imperial Brands, consensus analysts estimate earnings per share to grow 5.2% annually through the end of 2026. Return on equity is forecast to be 52.5% by this time.

One risk the stock faces is that this transition fails, allowing its competitors to gain market share at its expense. Another risk is future legal action for health problems caused by its products in the past.

However, April 9 saw an update from the company stating that adjusted profit for H1 this year will be higher than H1 2023. Last year, operating profit rose 26.8% on the previous year — to £3.4bn. Earnings per share also rose sharply — up 52.1% to 252.4p.

Low value

The third factor for me is that a stock should be undervalued to me relative to its peers. This is to reduce the chances of a large, sustained share price decline wiping out all my dividend gains.

In the case of Imperial Brands, it trades at just 6.8 on the key price-to-earnings (P/E) stock valuation measure. His peer group average is 14.6, so he is considered underrated on that basis.

by how much A discounted cash flow analysis shows that it is currently undervalued by about 63%.

Its fair value, at the moment, is around £50.51, compared to the current £18.69. There’s no guarantee it will reach that fair price, of course.

Big another income generator

So, an investment of £20,000 in Imperial Brands shares earning 7.9% per annum would give a total investment of £43,954 after 10 years. It will pay £3,328 a year in profits, or £277 per month.

This is provided that the average output remains the same (it may rise or fall) and profits are reinvested in stock. This is known as ‘dividend compounding’ and is the same idea as compounding interest in a bank account.

Over 30 years, on the same basis, the investment pot would be £212,293. It will pay £16,075 a year in profits, or £1,340 a month.

Inflation will certainly reduce the purchasing power of income. However, it does highlight that relatively small investments in the right stocks can generate significant passive income if the profits are reinvested.

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