One of my biggest goal in life is to achieve financial freedom and generate passive income to sustain my desired lifestyle.
No more worrying about work…
Spend more time with family and friends…
Not having to worry about money anymore…
One of the ways to achieve this is by investing in stocks to generate dividend income passively.
What is a dividend?
It is a portion of earnings from the business distributed to shareholders. Businesses such as Real Estate Investment Trust (REITs) tend to payout a higher portion of earnings than most businesses. What is dividend yield? It is an expression of dividends paid over current share price.
Creating a dividend income portfolio
Often, mature companies with stable earnings that doesn’t need to reinvest as much in itself payout dividends to shareholders quarterly. It is a good way to reward shareholder loyalty, attract long term investors and shows the financial strength of a business. As an investor, the goal is to build a portfolio of dividend paying stocks across various sectors.
Over time, you will generate enough income to achieve your goal.
Common mistakes of dividend hunters
Most investors are attracted to companies with high dividend yields, which might seem like a good buy but they may also be a trap. I realized that some investors adopt the wrong approach when investing for dividends.
Common mistake is to invest purely on dividend yield, some investors purchase stocks just because they are trading at 20% dividend yield. It does look good on paper, but this figure does not tell you anything about the business.
High dividend yields are not sustainable, a business who just sold its assets may choose to pay off a one time dividend. For example company ABC sold its assets for $200 million, its directors has decided to retain $ 100 million as cash reserves and pay out the remaining $100 million as dividends. This is obviously not a sustainable form of dividend income.
Investors might fall into the trap of buying bad businesses who are divesting assets and returning money to investors. In this article, I’d like to share some insights into dividend investing and how you can earn sustainable dividend income, read on.
How to select quality dividend paying stocks for your portfolio
- Start by looking for the right business
As mentioned earlier, dividends are a portion of earnings and key to dividend investing is to look for healthy businesses with strong cash flows. You can start by looking for mature businesses in industries such as REITs, Consumer monopolies, Healthcare, Utilities, Telecommunications, Logistics or Public transportation services. Look for businesses thriving in stable industries, avoid industries with rapid change.
2. Understanding the numbers
How do we measure cash flow? Start by looking for clues if the business is allocating capital efficiently. Measure the returns on tangible assets or return on equity, this will give you an idea of how well the business is generating cash flows on its investments.
Businesses with higher profit margins tend to have wide economic moats, by comparing its profit margin among its peers, you can tell if the business has a competitive advantage.
Measure the level of debt on its balance sheet, and the amount of debt the business is consuming yearly. High levels of debt has a significant impact on cash flows due to fluctuating interest payments. Do check if those are long-term loans or short-term borrowings.
Payout ratio tells you how much of its earnings the business distributes as dividends, mentioned earlier, REITs distributes higher portion of earnings due to regulations. If you’re investing in non-REIT, compare the payout ratio with its peers and understand why the business is paying out the amount as dividends.
3. Valuation is key
Even if you’ve found the perfect business that fits the bill, you have to buy it at the right price. However, value is relative and subjective. Value is relative to the earnings power of the business or its underlying assets. Value is subject as each individual has different expectations of their investments and required rate of return. Importantly, you must identify a valuation method that makes most sense to you and nature of the business. For example, a business with excellent capital efficiency and generating strong cash flows should be valued based on its earnings power or future cash flows.
Capital allocation and diversification is crucial in investing, as retail investors, we don’t have to power to influence decisions of the company. Even after going through this checklist for the perfect business, there are many other factors that will influence the future and prospects of the business. Hence, it is important for us to allocate capital prudently into each stock. Ideally, one should diversify across 20-25 stocks.
5. Reinvest Dividends
Biggest mistake beginner investors make is to spend away dividends. Studies have shown that by reinvesting dividends, your portfolio benefits from greater exponential growth and higher compound rate.
Earning dividend income through Real Estate Investment Trust (REITs)
One of the best methods to earn dividend income is by investing in Real Estate Investment Trusts, or REITs are the fastest and easiest way to begin property investing and to be part owner of commercial real estate across Singapore, Asia and Europe. REIT is a trust company that acquires properties to be managed, developed and eventually sold. REITs are funded by pooled money from investors and sometimes will take on loans to fund its investments. REITs are known to be stable income generating assets, that distributes 90% of its Net Operating Income to unitholders.
Advantages of investing in REITs:
✓ Start as little as $1000 – REITs are listed in the stock exchange, hence follows
regulations set by the exchange regulator. In Singapore, the minimum quantity of
shares per transaction is 100. If you looking to buy CapitaMall Trust at $2 for 500 shares, the minimum capital outlay will be $1000.
✓ Diversification – to own a physical industrial building or a shopping mall is not
exactly plausible for most retail investors, but that doesn’t mean that you can profit
from this lucrative market. REITs provides exposure across the various types of
properties such as residential, retail and industrial properties without the need to
fork out huge deposits or incur expensive property taxes to get started.
✓ High liquidity – Selling or buying a physical property can take months to process, and
this can be an obstacle to ride short-term market trends. As a listed instrument in
the exchange, REITs are transacted daily in open market activity.
I have compiled a short E-Book here to get you started with REITs, I’ll show you how you can build a simple and stable investment portfolio and generate multiple streams of passive income.
This is what you will learn:
Lesson 1 – Why the rich invest in properties and the reasons why it is so attractive.
Lesson 2 – What are REITs? What are the types of REITs you can invest in?
Lesson 3 – Advantages of REITs and why owning them might be better than physical properties.
Lesson 4 – What factors to consider before investing in REITs?
Invaluable and practical investment insights that you can implement immediately!