For: Individuals interested in Dividend Investing, Early Retirement, Passive Income, finding Dividend Stocks.
In this article, we focus on:
- 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.
- Real-life case studies using Starhub and Singtel.
- 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.
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.
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.
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…
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.
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.
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.
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.
Represented as a Graph:
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.
Had you bought the stock in 2014 at $3.62 and sold recently…
|Loss in Share Value||$0.64 per share|
|Dividends collected over 4 years:||$0.70|
|Net Position||Gained $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.Steps 1 & 2
(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.) findsFree 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)
- 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.
- 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.
- 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.
- 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.
- 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
Christopher Ng Wai Chung is such a guy. Full disclosure, he works with us at Dr Wealth.
His qualifications are three-fold:
- His Dividend income exceeded his expenses by the time he was 33.
- 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)
- His 2018 monthly averaged passive income from dividends is approximately $6,000-8,000. Something most people only dream of.
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.
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