Dividend Investing: The Ultimate Factor

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For: Individuals interested in Dividend Investing, Early Retirement, Passive Income, finding Dividend Stocks.

In this article, we focus on:

  1. The Ultimate Factor to identify good businesses to invest in for passive income as well as how the lack of this factor leads to losses.
  2. Real-life case studies using Starhub and Singtel.
  3. A list of factors to help you screen the numerous stocks listed so you can dig for gold while avoiding trash.

First: the ultimate factor for investing in companies that provide consistent, sustainable dividends is known as the company’s free cash flow yield.

Why?

Dividends are typically paid from free cash flow yield.

When dividends are affected, the share price of the company is also affected. (We will examine Starhub and Singtel later to show you this effect)

This is relevant for you because as a passive income investor, you want your passive income to come steadily and consistently.

Without it, you have no peace of mind.

You will live in constant fear of the underlying business dying out and taking a gigantic hit to your invested capital. (Google what happened to Hyflux and Noble Group)

Take a look at this graph.

$10,000 invested at 10% yields, with dividends reinvested. Total reinvestment at $1,200 a year ($1,000 dividends + $200 cash from savings)

As you can see, if you manage to avoid losing money, your growth snowballs rapidly after a couple of years.

This is due to the power of compound interest. This means instead of spending the dividends you received, you reinvest it into solid businesses that will pay you even more dividends for owning even more shares.

It’s an everlasting cycle of growth.

As you can see above in the graph, once you hit those years with massive grey bars that represent increasing interest gained, you get to actually retire without worries, living off of your dividends every year.

But what happens if you lose 70% of your invested money in Year 2029 or Year2031?

You get blasted back five maybe even six years.

And then you have to restart the cycle of waiting for compound interest to build your wealth again!

It will take you years to recover. That’s assuming you don’t take another massive hit from the wrong investments.

So how do we properly sort out the winners and the losers when it comes to dividend investing?

We look at a company’s Free Cash Flow Yield (FCFY).

#1 – Understanding Free Cash Flow Yield to Avoid Shitty Investments

First, to understand Free Cash Flow Yield, we must understand free cash flow.

It becomes easy to understand free cash flow if you look at yourself as a business.

Cash-coming-in MINUS Cash-Going-Out = Free Cash Flow

We mentioned dividends are paid from free cash flow.

But to fully realise the impact of why free cash flow is so critical, and how it can improve or decrease a share price, we’re going to use an analogy to make it simple to understand.

In fact, it’s going to be so simple you can walk away and explain it to your relatives the next time they ask you, “how to invest?

#2 – Parents owning Children as a Business

To use the analogy, imagine you’re the parent and your now adult son/daughter are “businesses” you own stocks in.

Controversial, but bear with me.

Now imagine you collect dividends from your salaried son/daughter in the form of cash every month. It’s nice and consistent at first when they have not much to pay for.

Maybe they haven’t gotten married yet. Aren’t dating yet. Aren’t buying cars or houses yet. Don’t have children of their own to feed…

Yet.

But what happens when they start having those and they can’t increase their income?

Free cash flow goes down. Maybe they buy a car that’s too expensive. Maybe a house mortgage gets too high thanks to interest rates.

Worse.

What if they lose their job?

Free cash flow practically disappears.

Can you still get paid dividends?

The answer should be obvious.

If they have so little for themselves, you almost always become their last priority. Maybe your children won’t place you as their last priority.

But the company is not your child. And you are definitely their last priority.

#3 – But my company still pays me dividends! What do you have to say about that?

Well, it’s simple.

If there is more money flowing out than money flowing in, the business loses value.

If your child has to pay you “dividends” after they’ve lost their job, that money has to be coming from somewhere.

It’s probably coming from their savings. Or coming from a loan.

What happens in the long run? He/she will have less and less money and/or more debt.

Both are undesirable in a business.

Always remember. When there’s more money flowing out than in, the business is losing money.

And that will almost always reflect in the share price.

In the rare occasion it doesn’t, you might want to check into why. Perhaps the company secured a new major contract. Maybe sentiment is strong that the company will recover its ability to earn profits.

Generally, I would avoid betting on the yet uncertain future of a company.

No one can truly predict the future after all. That’s why we look at the numbers of a company to decide if they are worth investing in before we dig further.

Let’s take a look at real-world case studies of free cash flow problems.

Case Study 1: Think Starhub is good? Think again.

Source: Dr Wealth Screener

Starhub paid out $0.20 of dividends per share from 2013-2016. In 2017, they paid out $0.16 per share.

And yet their Free Cash Flow Per Share has consistently been less than the dividends paid out. Note that free cash flow already accounts for a company’s earnings.

The result?


Source: Yahoo Finance

Look at that price plunge! From $4.62 in 2013 to $1.59 currently!

Had you blindly bought Starhub on the back of it’s brand name and its recognisability, you would have lost 65% of your invested capital.

Had you followed the free cash flow test, Starhub would never have been a valid candidate for investing in the slightest.

It wouldn’t have even come close.

Case Study 2: What About Singtel?

Well if Starhub sucks, maybe we should look at the main competitor, Singtel.

Let’s find out how Singtel did.

Source: Dr Wealth Screener

Represented as a Graph:

Source: Dr Wealth Screener

Pay attention to the purple free cash flow line.

It barely beats out dividends each year and fell below the blue dividend line for 2016 and 2017.

If Singtel had not been able to improve free cash flow, it’s share price might have suffered tremendously.

In fact…

Source: Yahoo Finance

Had you bought the stock in 2014 at $3.62 and sold recently…

Bought$3.62
Sold$2.98
Loss in Share Value$0.64 per share
Dividends collected over 4 years:$0.70
Net PositionGained $0.06 cents per share

To be clear, this is assuming you had taken dividends and not reinvested it. Also, had you really performed this investment, you might realise that gaining $0.06 cents on the dollar (1.65% gain, or 0.41% per year over 4 years) leaves you at a huge negative when you account for inflation (which is approximately 2%).

You might have done better leaving that money in your CPF Special Account, which would have gained you 4% a year, and 16% in 4 years.

Let this serve as a lesson.

Always look at free cash flow. Don’t just buy based on the brand’s name.

So How Do You Calculate Free Cash Flow Yield?

Here’s the best part.

You don’t really have to!

Some brokerage platforms will be able to determine free cash flow yield for you by themselves.

In case you’re not with one that can provide such a feature, here are the formulas so you can check by hand.

Step 1: Free Cash Flow = Operating Cash Flow – Capital Expenditures

Step 2: Free Cash Flow Yield = Free Cash Flow Per Share / Market Price per Share

Step 3: Has Free Cash Flow Yield been consistent and sustainably higher than the dividend yield for the past 5 years? Don’t bother if it hasn’t. (Note, one year of failed free cash flow can be OK if you’re looking at an asset-heavy industry like a REIT. Sometimes, just for one year, they have to expend some amount of cash on the maintenance of the business. The important aspect is if they have continuous depletion of their cashflow over several years running.)

Steps 1 & 2 finds Free Cash Flow Yield. Step 3 sees if the company is worth looking further into.

How to Dig for the Right Dividend Stocks (5 Factor Model)

  1. Look at High Free Cash Flow Yield Versus Dividend Yield: Compare 5 years of free cash flow yield to dividend yield. If the free cash flow yield has been decreasing over 5 years, we drop it from consideration. Remember that we want sustainable, consistent, free cash flow yield vs dividend yield.
  2. Look for Fantastic Profitability (rank the companies. look only at the top 20%): A company’s profit margins determine its free cash flow. This is just a logical extension of valuing companies based on their free cash flow per share. If they have better profit margins, it stands to reason that they should have higher cash flows (unless they have debilitating capital expenditures and maintenance, which looking at free cash flow yield for the past 5 years should already have eliminated.) Look only at companies in the top 20% of profitability. We don’t compromise on this.
  3. Target High Dividend Yields (we rank the companies and look only at the top 20%): We want to maximise dividends collected. The higher the better. It is the next natural step after we ensure the stock is safe, sustainable, and highly profitable.
  4. Stable and Unaffected Businesses: We want to be defensive and achieve consistent results over time. We only invest in businesses that are relatively stable and are relatively unaffected by recessions or economic slowdowns. Look into sectors that provide essential services such as medicine, shelter, electricity, fuel, food, water.
  5. Low Debt (we rank the companies and look only at the bottom 20%): We don’t want companies that are loaded up and high on debt.

This 5 rules for investing should reduce the number of companies you have to a reasonable number.

Once you have them gathered into a list, remember that what you want to do is gauge the long term sustainability or growth (if possible) of the business.

Dividend Investing Magician

I spoke about using free cash flow yield to gauge a company’s risk profile and how to ensure that the company at least passes the safety check.

What I haven’t spoken about is how some people are able to use mathematics to find a zone where returns are hyper-maximised and risk is choked off to a corner.

Christopher Ng Wai Chung is such a guy. Full disclosure, he works with us at Dr Wealth.

His qualifications are three-fold:

  1. His Dividend income exceeded his expenses by the time he was 33.
  2. He retired by 39. And his retirement was not threatened by having another child or by going back to SMU to study law. (he was admitted to the bar, June 2018)
  3. His 2018 monthly averaged passive income from dividends is approximately $6,000-8,000. Something most people only dream of.

Chris’s calculations shows that an average person with $10,000 after 2 years of savings (or about $400+ a month), can begin investing, and after 5-8 years of investing, can begin to accumulate enough passive income for retirement. (we are using an approximate sum of $1500 a month of passive income as the target)

I’m inclined to believe him since he did exactly that – retire at 39 with $6,000 to $8,000 of passive income a month. Walking the talk is perhaps the most important thing I look for in a trainer. And it’s also the most important thing you should look out for.

You can check him out here if you want to cut down on the time needed actually to retire earlier and make maximum returns with minimal risk.

Who We Are, What We Do, And Why We’re Doing It

“If you don’t find a way to make money while you sleep, you will work until you die.”

Warren Buffet

There’s really only 2 ways to make money while you sleep.

  1. You open a business OR
  2. You learn to invest in a business

We’ve chosen to be investors because the chances of succeeding are higher and the work required far less.

Further, the cost of investing is far less and far more efficient in recent times thanks to the growth of the web.

The average person on the street now has far more avenues to grow their wealth.

Our aim is to bring the education that matters to you.

Part of that aim is to publish excellent, well-researched content backed by performance and historical returns so YOU too can benefit from it.

If becoming free of your salary and work to live the life you want is something you’re working towards, feel free to follow us and subscribe.

The choice is yours.

Sincerely,
Irving

  • Hi,
    Which website did you use to derive the dividends, earnings and free cash flow graph?
    Two of e brokers that I use Do not offer free cash flow data as part of their screener

    • Hi Jason, we used our personal in house screener for that. you might have to refer to some of the more advanced brokerage platforms or engage screener providing software services in order to get that information readily available.

      However, dividends and earnings per share can also be calculated by hand. You can find dividends and earnings under yahoo finance. you will need to download the company’s financial statements to ensure you find total shares to divide by. Can also try this website: (https://finbox.io/screener), but the scanner for SEA markets and China not up yet. will apparently be rolled out at the end of the month.

  • You mentioned:
    Free Cash Flow = Operating Cash Flow – Capital Expenditures

    Where is Earning & Dividend in this equation? Or Dividend is paid out from Free Cash Flow, assuming Free Cash Flow > Dividend?

    I think this part is not clear. Thanks!

    • earnings typically is part of cash flow.
      dividends are typically paid from free cash flow. And free cash flow per share will give you a measure of how much cash they have per share vs how much is due via dividends. some companies make the error of continuing to pay out high dividends per share just like StarHub and Singtel despite that leaving them net negative in overall value. this endangers you as the shareholder despite the steady dividends as can be seen reflected in the share price. if they had slashed the dividend yield, they would also be affecting the share price. but that would be more obvious so its better for the retail investor to understand how to detect if their companies are going to plunge in price versus depending on the company to come clean. your alarm bells should generally be ringing once earnings drop but dividend yield stays the same.

  • In my opinion, one more factory consider is the NAV.
    Some coy has very high depreciation (+ cash-flow) and it affect the overall NAV overtime. At the same time, the Capex is marginal, so it distorted the FCF.

    One example I can think of is KepInfra Tr. Their NAV is decreasing over the years, and some years their FCF payout ratio is -ve.

    Please comment. Cheer!

    • Hi RN! It’s technically possible for a company to depreciate in value. But then it will have to be a high asset value company with rapidly depreciating assets. Infrastructure tends to not depreciate as fast. If profitability and cash flow remains strong and consistently high, then the company won’t have had trouble with devaluing assets because they can simply purchase more when necessary. But you are right in that net asset valuation can serve as an additional check mark for people to look at when considering a stock! if NAV goes down over time, and somehow free cash flow and profitability stays up, will have to dig further to find the source.

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