Looking Out at Dividend Investing
In the wake of the 2020 pandemic, I’ve personally seen and heard of so many stories of people losing their jobs, give up any increments for the year (& any hope for bonus), businesses had to close their operations and such. Essentially all leading to the loss of income.
This had also turned into a wake up call to a lot of people that relying on a sole income can be challenging in our current world. It was also shown that the wealthy typically have multiple sources of income. More importantly, one should start to build on that passive income source.
If you are currently investing in the stock market, then it won’t be a surprise to have heard of the term “Dividend Investing”, which is investing into a dividend paying stock in order to generate regular income.
This is one of the best ways of building on the passive income and is readily accessible by anyone. You just need to have a trading account to kick start your investing journey. Dividend Magic is one of the poster boy of this with his widely followed portfolio freedom fund which can be seen on his website.
Then… let’s talk dividend.
The concept of dividend
Dividend is the distribution of some of a company’s profits to the company’s shareholders.
In essence, a business operates to make money – that means profits. Whatever profits made by the company is kept in the company’s bank accounts under the company’s name.
As the company is a separate legal entity by itself, nobody has access to the company’s bank account other than the company itself. Not even the owners of the company. *This is a separate topic altogether and shall not be discussed here.
Then what happens to all those nice profits sitting in the bank account?
- Do nothing (for rainy days like our own personal emergency funds)
- Uses it for expansion
- Owners cash out into their personal pockets
Relating to point 3, the owners of the business (i.e. shareholders) get to enjoy the profits made by the business when the company distributes them via dividends.
Two Key Metrics
When we are investing for dividends, there are two very important dividend metrics that I pay particular attention to.
1) Dividend Payout Ratio
This metric tells us how much of the company’s earnings are being paid out as dividends.
Assuming a company that generates a profit of RM1,000 has a 60% payout ratio, it will pay out RM600 in dividends and keep RM400 to invest in the business for expansion or other business purposes.
The formula goes like this:
Why is this important?
You might think that the higher the payout ratio, the better. However, this is detrimental to you in the long run.
Think about it: If the business pays out 100% of its profits to its shareholders, then what happens to the business? It will not have the capacity to invest in the growth of the business. Worse, next year’s profit will most likely be less because costs (such as materials and staff costs) will increase.
Let’s also not forget that when we invest in dividend stocks, we are also looking to invest in a business that has good prospects and not one that is stagnant or deteriorating.
A big warning signal should be ringing if you see a payout ratio of 100% or more. This means that the company is digging into past profits just to sustain its dividend payments, which is not sustainable in the long run.
On the other hand, if the payout ratio is low then I will look deeper into the company’s expansionary plans as to what they are investing in with the profit that is retained in the company. My personal threshold here is 30% and lower.
What is an ideal payout ratio?
This article here sums it up and is quite in line with my thinking. I personally look to a maximum of 70% payout ratio. Exception to this is if its a Real Estate Investment Trust (REIT) as it will payout more than 90% due to the tax incentive that it will enjoy.
2) Dividend Yield
As should be familiar by all, this metric tells us how much income we get per dollar we invest into the company. In other words, our “yearly interest” for investing in the company.
If we invest RM1,000 into a share that has a dividend yield of 5%, we would expect to get RM50 per year in dividends.
The formula goes like this:
In my previous post, I mentioned that I am only looking at a dividend yield of above 3% and this is to ensure that I get an income from dividends that is at least on par of normal fixed deposit rates (before all the OPR cuts).
Looking at this formula, there are 2 points that require special mention and attention:
- This is based on historical dividends paid so far and in no way represent that it will be the same in the future. As we saw from the slew of dividend cuts this year due to the pandemic affecting most businesses, it is important to assess the ability of the companies to continue paying dividends and sustaining the yield moving forward. I would pay close attention to the business future prospects, the historical dividend track record, profitability of the company (& the payout ratio) and the net cash position of the company.
- High dividend yield does not necessary mean that it is a good investment. As the formula suggested, the yield can be high either because DPS increases or share price falls. If it is the latter (check the historical prices for reference), then there may be cause for concern. I would research into the fundamentals of the company and also to ascertain the reason for the fall of the share price to see if it is a good buy or a sign of a sinking ship.
Shortcut
Luckily for us, a lot of the investing or finance websites out there already have these 2 metrics covered. Here’s a snapshot of how we can find it in i3Investor’s financial highlight section of any stocks.
- DY = Dividend Yield
- Payout % = Dividend Payout Ratio.
Important dividend dates to look out for
There are 4 dividend dates that we need to know:
- Announcement Date: The date that the company announces that they are paying dividends, how much will the dividend amount be and reveal the other 3 dates.
- Ex-dividend Date: THE date that we must pay attention to. Investors who hold shares until this date will be eligible to the declared dividends. If you are looking to buy into this company and to be entitled for dividends then you have to do so BEFORE this date. On this date, the share price will also be adjusted for the declared dividend (more on this below). If you sell your shares on this date, you will still be eligible to the dividends.
- Entitlement Date: The date whereby the company will check the list of shareholders to see who is eligible for the dividends. This is more of an internal date.
- Payment Date: Ka-Ching date. Our dividend gets deposited into our accounts.
Why does the share price drop on Ex-dividend Date?
The ex-dividend date is the cut-off date to determine who is eligible for dividends. This also means that the company has committed on this date to pay dividends to those who hold their shares.
Remember that the company takes its profits to pay dividends. This also represents the shareholders taking out some profits from their investment in the company.
As an illustration:
Let’s say we are invested in 1 share of ABC Bhd with RM9. The current share price of RM10 (RM1 capital gain from our cost of investment) and just declared a dividend of RM0.50 per share.
On Ex-dividend date, the share price will drop from RM10 to RM9.50 due to the RM0.50 dividend.
At this point, our “existing investment” in ABC Bhd is comprised of:
- RM9.00 in original investment;
- RM0.50 in capital gains; AND
- RM0.50 in cash via dividends
The share is now valued at RM9.50. We have taken out RM0.50 from the total share value of RM10.
For a new investor, he can purchase 1 share of ABC Bhd with RM9.50 as that is the existing value of 1 share after the dividend payout to the existing shareholders.
Closing Thoughts
There you have it. Some basic information of dividend investing.
One of the main benefits of dividends as passive income in Malaysia is that dividends are exempt from tax. They call it single-tier tax system. This just means that the company already pays tax as part of their business to derive the profits. Hence, when the company distributes dividends, it is distributing profits that are after company tax.
This also means that this source of passive income is *technically* tax-free income for us.
Happy investing and generating passive income from dividends!
