My long-preferred method of making passive income (money that comes from minimal effort) is investing in shares that pay dividends. The only real work involved is picking promising stocks in the first place and then monitoring their progress periodically.

I started doing this around 35 years ago, which turned out to be a good thing to do. The earlier an investor begins this journey the more time there is for dividends to be paid.

Additionally beneficial is that the more time that passes, the greater the chance that a stock can recover from any transitory shock.

How should the stocks be chosen?

An obvious starting point when stock-picking is a high yield. The core stocks in my passive income portfolio – designed to maximise dividend payouts – have an average yield of over 9%.

The second thing I look for is an undervalued share, relative to other stocks and to its fair value based on future cash flows. The more it is underpriced, the less likely it is that the dividend gains will be erased, in my experience.

And the final element I want is strong earnings growth prospects. It is these that will power increases in a firm’s share price and dividend over time.

A star example in my portfolio

Legal & General (LSE: LGEN) is a great example of these factors at work, I believe.

Itcurrently yields 9.1%, based on 2023’s 20.34p dividend and its £2.24 share price.

This is one of the highest yields of any FTSE 100 or FTSE 250 stock. By comparison, the present average yield on the former is 3.5%, and on the latter 3.3%.

Additionally, on the key price-to-sales ratio (P/S) of relative stock valuation, the firm trades at just 1.1. This is very cheap compared to its competitors, which have an average P/S of 2.6. 

A discounted cash flow analysis shows Legal & General shares to be 59% undervalued at their present price. So a fair value for them is £5.46, although they may go lower or higher than that.

And finally on growth prospects, consensus analysts’ forecasts are that its earnings will increase a stellar 28.1% each year to end-2026.

How much passive income can it generate?

So, £6,000 (£500 saved each month for a year), for example, invested in the stock will make £546 in dividends. On the same average 9.1% yield, this will rise to £5,460 over 10 years, and to £16,380 after 30 years.

A principal risk for Legal & General is the high level of competition in the sector that may squeeze its profit margins.

As it stands though, analysts forecast its yield will rise to 9.8% in 2025 and to 10% in 2026.

The power of dividend compounding

It is crucial to understand that using the dividends to buy more of the shares (‘dividend compounding’) can vastly increase returns over time.

The dividend payments after 10 years of doing this on the same 9.1% average yield would be £8,855, not £5,460. And after 30 years on the same basis they would be £85,055 rather than £16,380.

Adding in the initial £6,000 investment, the total Legal & General shareholding would be paying £8,286 a year in passive income!

Although the buying power of the money would be less by then, it shows what big returns can be made from much smaller beginnings.