Generating a second income gives us more choices in life – somewhere nicer to live, more exotic holidays, or an earlier retirement perhaps.

Better still is if this extra money can be made with very little effort. This can be done through investing in companies that pay high dividends.

One such firm I bought for this very purpose is Imperial Brands (LSE: IMB).

The FTSE 100 tobacco and nicotine products manufacturer has a solid history of paying high dividends.

Over the past four years, working back from 2022, it paid 7.6%, 8.9%, 10.1%, and 11.3%, respectively.

The total dividend payment for 2023 was 146.82p. This gives a yield of 7.4% based on the current share price of £19.80.

At this price, around £17,000 — the average UK savings account amount — would buy 858 shares in the firm.

The magic of dividend compounding

‘Dividend compounding’ is the same principle as compound interest, but rather than interest being reinvested, dividend payments are. The difference in returns between withdrawing dividends paid each year or reinvesting them is massive.

For example, my 7.4% dividend return on £17,000-worth of Imperial Brands shares would make me £1,258 in the first year. If I withdrew that, I would receive another £1,258 the following year, provided the dividend remained the same.

If I kept withdrawing my payouts and the dividend stayed the same, I would have made £12,580 in dividend payments after 10 years.

However, if I reinvested the dividends into Imperial Brands stock, I would have made an extra £18,550 instead.

This would mean £35,550 in total, paying £2,528 a year in dividends, or £211 a month.

After 30 years, it would be £155,461, paying me £11,056 a year in passive income, or £921 every month.

Can the high dividends be maintained?

Both a company’s dividend payouts and share price are powered by earnings and profits over time.

Imperial Brands, like other companies in the sector, is currently transitioning away from tobacco products and towards nicotine replacement ones. So, a primary risk here is that this transition falters, allowing its competitors to gain a market advantage.

However, the underlying business looks very strong to me. Its full-year 2023 results showed operating profit up 26.8% from 2022, to £3.4bn.

In H1 2024, its adjusted operating profit rose 2.8% year on year. Net revenue growth for its next-generation nicotine products increased 16.8% in the period.

Overall, consensus analysts’ estimates are that its earnings per share will rise by 5.9% a year to end-2026. Return on equity is forecast to be 47.9% by that point.

A potential bonus

I always try to buy stocks that look undervalued against their peers. First, because there is less chance of my dividend gains being wiped out by big, sustained share price losses. And second, because there is more chance I can make money on a share price rise over time as well.

A discounted cash flow analysis shows Imperial Brands shares to be around 62% undervalued at their current price of £19.80. Therefore, a fair value would be around £52.11, although this does not guarantee it will reach that level.

Given its solid high dividend pedigree, its strong earnings forecasts, and its relative undervaluation, I will be adding to my holding soon.