This cash cow passive income stock looks set to pay 10% dividends!

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For a long-term passive income investment, we don’t always want the stocks with the biggest cash on offer today.

No, double-digit dividend yields often don’t last and only get that high because the earnings outlook is weak. And they tend to fall.

But at British American Tobacco (LSE: BATS), I see a 10% dividend yield I reckon might just be sustainable. Yes, the yield is high because the share price has fallen, but in this case, I think the market has got it wrong.

Out of fashion

Let’s get the obvious risk out of the way. It’s that tobacco is going out of fashion. But is it really? In the 2023 year just ended, revenue from New Category products climbed 16% to £3.3bn. And it hit its first profit milestone two years ahead of target.

In the meantime, British American Tobacco sells around 300 brands in 180 global markets!

For investors who still think this is an industry that’s fated to an end, well, maybe don’t buy shares in it. But if we do, how much passive income might we be able to generate?

Compound magic

The real beauty of a 10% dividend yield comes from compound returns. If it’s maintained, after one year we’ll have enough income to buy 10% more shares. Then next year we’ll have enough for 11% more shares, and so on.

And the difference even a modestly bigger dividend can make can be amazing. Investing £500 a month with a 9% annual return could build a pot of about £860,000 in 30 years. But up it by that extra percent to 10%, and we could be looking at £1.04m!

Just an extra 1% can bring in an extra £180,000 over 30 years.

Full ISA allowance

I would never put all my cash in one stock, mind. And it doesn’t matter how big or reliable the dividend. Something can always go wrong, and I just wouldn’t take the risk.

But what if we could use our full £20k Stocks and Shares ISA allowance every year, and we put it all into a 10% return like the British American Tobacco dividend?

We could have £1m in 19 years. Or £3.5m after 30 years.

Dividends for income

So to sum up my secret (that’s not so secret really). To retire with a decent passive income, we need to build up a healthy pot of cash. And I can think of no better way to try for that than with dividend-paying UK stocks. Well, nothing that doesn’t carry a lot more risk, at least.

It has to be a diversified set of stocks in different sectors though.

So I hold Lloyds Banking Group shares, for example, with a forecast yield of 6.1% (and rising). I go for housebuilders too. Their dividends are shaved a bit now, but in the long term I expect a good cash stream.

I doubt I’ll achieve an average 10% a year from a diversified portfolio. But looking at this one example shows the kind of thing that could be possible.

Should you invest £1,000 in British American Tobacco right now?

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Alan Oscroft has positions in Lloyds Banking Group Plc. The Motley Fool UK has recommended British American Tobacco P.l.c. and Lloyds Banking Group Plc. 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.