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.

Most investors are drawn to companies with high dividend yields, they are drawn to the idea of receiving steady passive income through dividend investing. I have nothing against that, in fact, I share similar goals in achieving financial freedom through dividend investing. However, 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 at times, 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. As explained, 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 achieve sustainable dividend income.

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, Tele communications, Logistics or Public transportation services. Look for businesses thriving in stable industries, avoid industries with rapid change.

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 amongst 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.

Read: 5 ratios to determine financial health of a business

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.

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.

Read: 3 quick & simple ways to value a stock

Diversify

Capital allocation and diversifying as a portfolio is a crucial part of investing, as an individual retail investor, 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.

Summary

In my view, dividend investing is not about buying the highest yielding stock available. It is about identifying stable businesses and predictable cash flows while buying them at a reasonable price. Investors shouldn’t be sucked into the trap of buying bad businesses that occasionally pays huge dividends to entice new money.