3 Rules For Profitable Dividend Investing

In Singapore, many investors are drawn to dividend stocks as a means to generate consistent income from their investments.

In this article, I distil 3 rules of investing in dividend stocks from a decade plus of investing in them - predominantly in Singapore, Hong Kong, Japan and the USA.

These rules are forged from experience - from both wins and losses over the years.

Dividend investing is one of the core strategies we use - and has an important place in our portfolio.

I hope you find them useful so you don't have to make the same unnecessary mistakes as I did.

Rule 1- Don’t Be Misled By High Starting Yields

 An unusually high dividend yield can actually be a red flag.

Often, high yields are indicative of a stock whose price has fallen substantially, making the yield look artificially inflated.

This frequently happens with so-called “value traps” - companies facing declining prospects where the business fundamentals and growth opportunities do not support the high yield.

For example, the average dividend yield on Singapore’s Straits Times Index (STI) is around 4 percent.

So if you come across a stock yielding 6-8 percent, it warrants further investigation before investing.

The share price may have plummeted due to declining profits, excessive debt levels or other challenges faced by the business.

The high yield likely is not sustainable over the long run.

Rule 2 - Focus on Sustainable Dividends, Not Starting Yields

Rather than fixate on dividend yields, investors should focus their analysis on the sustainability of a company's dividend pay-outs.

Two key indicators of sustainability are the dividend pay-out ratio and free cash flow.

The dividend payout ratio indicates what percentage of earnings is being paid out as shareholder dividends.

Here is an example to illustrate payout ratio:

Suppose a company earns $2 per share in net income last year.

During the same period, it paid out dividends totalling $1 per share to shareholders.

To calculate the payout ratio, we divide the dividend per share by the earnings per share.

Dividend Payout Ratio
= Dividends per Share / Earnings per Share

Payout Ratio
= $1 Dividend per Share / $2 Earnings per Share

Payout Ratio = 50%

In this case, the company paid out 50% of its net income to shareholders as dividends.

The remaining 50% of earnings can be reinvested into growth opportunities, debt repayment, share repurchases or held as excess reserves on the balance sheet.

A 50% payout ratio is generally considered reasonable and sustainable.

Ratios above 70% warrant more scrutiny to understand if they are funded by debt or drawing down cash balances to support what might be an unmaintainable dividend obligation.

The goal is for dividends to come mainly from consistent underlying profitability of the business.

Next, strong free cash flow generation is also essential for consistent dividends.

Free cash flow boils down to the cash a business generates from its operations, minus what it spends on investments to maintain and grow the business.

Free Cash Flow
= Net Operating Cash Flow - Capital Expenditures (CapEx)

Net operating cash flow reflects the actual cash going in and out to run day-to-day operations.

This accounts for income, taxes, adjustments for non-cash items like depreciation, and changes in working capital.

CapEx reflects cash spent to invest in property, facilities, equipment etc. needed to sustain the business.

This covers upgrading machinery, opening new locations, and other long-term investments.

Subtracting CapEx spending from operating cash flows leaves you with free cash flow - the remaining cash the business can use for funding growth, paying dividends, building up reserves etc. without needing external financing.

Tracking free cash flow distils whether the core business throws off enough cash to support dividends pay-outs.

A high dividend payout ratio combined with weak free cash flow generation spells trouble.

The exception here is financial companies like banks and insurers, where traditional free cash flow analysis is not relevant for them due to their business models.

Rule 3 - Favour a Track Record of Dividend Growth 

When evaluating dividend stocks, prioritise companies with a consistent track record of increasing dividends over time.

Dividend growth indicates that earnings and cash flows are rising to support higher pay-outs.

Stagnant dividends can signal a weaker outlook for the underlying business.

You also want to own stocks where share price appreciation complements the dividends.

Total return
= capital gains / losses + dividends.

This is what ultimately matters.

Not just dividends alone.

The share price reflects changing business fundamentals, so avoid companies threatened by issues like disruption, commodity cycles or demographic shifts.

Special Rules for REITs 

Real estate investment trusts (REITs) warrant special mention.

REITs must pay out at least 90% of taxable income as dividends so it’s hard to compare them just based on distribution yields alone.

 I will cover them in a separate article as there are specific ratios and qualitative factors we look at.

Ending Thoughts

Rather than fixating on chasing the highest yields, savvy dividend investors focus on total expected returns and the safety of payouts.

Sustainable dividends must be backed by healthy pay-out ratios relative to earnings and free cashflow generated from a sound, growing business.

I hope this article prompts you to move beyond just looking at starting dividend yields to dive into much deeper analysis.