How passive income could help me make a million from shares

Generating passive income from stocks is usually discussed as a strategy for income investing. But there is no law that says we have to cancel the dividend.

By reinvesting dividends and targeting business growth, I use passive income strategies to build wealth for retirement. As I will say, I consider this to be a powerful technique that can yield long-term benefits.

The magic of compounding

Withdrawing dividends can be a great approach to income, but it can also limit portfolio growth. When we withdraw dividends, we effectively take away part of our investment capital.

Personally, I have never withdrawn a single dividend from my portfolio. I’m still working, so I want to build my stock as much as possible.

I used all the dividends to buy more shares.

In turn, the shares generate additional income for me, which I then use to buy more shares.

This approach is known as compounding – reinvesting previous income to generate more income in the future.

Compounding is a powerful growth technique over a long period of time. But it doesn’t necessarily give much stock price growth. For that, I rely on other techniques.

How I target stock price growth

Dividends represent a portion of a company’s profits. What is left can be reinvested in the business or used by the company to strengthen its financial position.

I am looking for a company that can successfully reinvest retained earnings, so that profits continue to grow.

In turn, this usually leads to steady dividend growth. And when dividends rise, very often the stock price does too.

One rule of thumb I use is to add a stock’s dividend yield to forecast dividend growth. The result is the total expected return of the stock over the next year.

This approach is based on the assumption that if a company’s dividend increases, the stock price will increase by the same amount, so the dividend yield remains the same.

Obviously this doesn’t always happen, at least not every year. There is no formal relationship between dividend payments and stock prices.

However, over the long term, my experience has shown that this is a reasonable approach.

One example is the FTSE 250 baker Greggs. Over the past 20 years, Greggs’ dividend has grown by an average of 11% per year.

Over the same period, Greggs’ share price rose by an average of 12% per year.

Obviously this stock price growth does not happen in a straight line. But it has happened.

Make a million

I think that if I can invest in dividend growth stocks with attractive valuations, I should be able to make a long-term average return of 10% per year.

At that rate, how much do I need to make a million?

If I invest £20,000 today and then add £200 to my portfolio every month, my numbers show that I could reach £1m in 33 years, based on a 10% annual return. Of course, I may not get any returns and may even lose money.

But the beauty of this strategy, if successful, is that when I’m ready to start drawing income from the portfolio, I don’t have to change anything. All I have to do is start withdrawing dividends, instead of reinvesting them.