Stock market

With an investment of less than £300 a month, this stock can generate £16,000 a year in passive income.

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The idea of ​​earning passive income is very appealing. Free time to pursue those lifelong dreams without being chained to a desk five days a week. Who would say no to that?

But it doesn’t come easy.

Making money usually takes time and effort, but for passive income, it’s possible to replace effort with savings. In other words, investing in dividend stocks and compounding the profits.

A collection of magic

Dividend stocks regularly pay a percentage per share. Reinvesting these payments can create a snowball effect of wealth accumulation.

Passive income

But there are plenty of dividend-paying stocks. London Stock Exchange But not all are equal. In addition to high yields, it’s also important to choose stocks with a strong value proposition and a track record of payouts.

Investment trusts or income shares are a good option as they usually pay reliable dividends. However, they usually have limited growth potential. The real diamond in the rough to find is an undervalued stock with a long history of consistent dividend payments.

A lesser-known specialist bank

A good example, I think, is Paragon Banking Group (LSE:PAG), the specialist lender and savings bank.

But investing comes with some risk and this is no exception. Much of its day-to-day operations involve lending, which is normal for banks, but there is also something to check. With £3.13bn in debt and just £1.4bn in shareholder equity, its debt-to-equity (D/E) ratio is alarmingly high at 221%.

It has nevertheless significantly reduced its debt position over the past 10 years, but an ideal D/E ratio would be below 100%. Growth has also slowed recently, with profit margins falling from 73% to 39% this year. And earnings are forecast to grow just 4.3% this year – well below the industry average of 14.7%.

So why do I like it as a dividend stock?

This £1.6bn FTSE 250 The partial play is a slightly-above-average dividend yield of 5%. While there are certainly plenty of stocks that pay higher dividends, I like Paragon’s track record and growth potential.

Apart from a brief pandemic break, it has paid a regular biennial dividend, which has risen from 7.8p to 37.4p in just 10 years. If the dividend continues to grow at this rate (which it won’t necessarily), it will pay out more than £1 per share over the next 10 years.

Moreover, the value of the shares is estimated to be undervalued by 53% using discounted cash flow analysis. This leaves a lot of room for growth.

Calculating returns

Paragon’s share price hasn’t done much over the past 20 years. But in the last four years since Covid, it’s been great. Since May 2020, it has gained 130%, with an annualized return of 23%.

Of course, past performance is not indicative of future results, but I think the UK stock market average of 7% per annum is a good benchmark.

An initial investment of £1,000 combined with a monthly contribution of £300 can create a pot of £4,720 in a year.

By reinvesting 5% of the profits and continuing to make monthly contributions, this could grow to £295,980 over 20 years. Taking into account the growing dividend, it could pay out £16,000 in annual dividends.

Of course this is by no means guaranteed, but it’s a decent chunk of spare cash every month!

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