One of the reasons to invest in stocks is to earn dividends.
Presently, many hold a view – “The higher its dividend yield, the better a stock is for investment for the long-term”. It’s simple math. If you invest RM10,000 into a stock that offers 3% in dividend yield, you’ll earn RM300 in annual dividends. But, if you choose to invest the RM10,000 into another stock that offers 6% in dividend yield, you’ll earn RM600 in annual dividends.
This seems to be a no-brainer.
Or, is that so?
As I write, I’d come across aspiring investors who carry this view and find such stocks using Google and screeners. Of which, they’ll be showered with a dozen of local stocks that pay above average dividend yields. But, the question is – “Are they all investible?”.
The answer is no.
Sure, as investors, we can utilise Google, ChatGPT, AI tools, and screeners to shortlist these stocks. But still, these stocks need to be vetted through in order to filter out stocks which are worthy to be invested and kept for the long-term over others that aren’t.
Here, I’ll share four steps that you can implement in 10 minutes to sift out high-quality stocks out of a pile of dividend stocks that you come across online. They are as follows:
1. Track Record of Dividends
Assuming you found A Bhd, a dividend-paying stock listed on Bursa Malaysia.
First, you can download its latest annual report to find its dividend track record in the last 10 years. This is crucial because we want to earn growing dividends from our stocks. Typically, stocks which delivered a consistent rise in dividends over time tend to pay out rising dividends in the future. The probability of this happening far exceeds others that failed to do so in the past.
Hence, if A Bhd had paid out rising dividends for the past 10 years, that is awesome. We’ll move on, assessing A Bhd with three more steps below. But, if A Bhd is one that failed to do so, we’ll pass on and dismiss it as an investment. This is because there are plenty of stocks which have successfully delivered growing dividends to their shareholders for years and are still attractive to be evaluated for long-term investments.
2. Sustainable Dividend Payout Ratio (DPR)
DPR is calculated as follows:
So, if A Bhd makes RM1.00 in EPS and pays out RM0.50 in DPS, its dividend payout ratio is 50%.
From above, we’d checked A Bhd’s dividend track record for the past 10 years. Since we had done so, we’ll check A Bhd’s EPS track record in that 10-year period. If A Bhd had generated rising EPS in that period, that would be a good sign. Of which, we would proceed to calculate the DPR for each year in that period to assess if its DPR is sustainable or otherwise.
Typically, stocks that have stable DPRs, which are kept below 100%, are seen to be sustainable. For stocks that constantly have above 100% in DPR, they will be seen as having sustainable DPRs. Thus, these stocks would be avoided by savvier investors.
Example of A Stock That Has a Sustainable Dividend Payout Ratio
3. Operating Cash Flows
Dividends are cash returned by stocks to their shareholders.
To have the ability to pay out higher dividends consistently over time, it is sensible for these stocks to first have the ability to generate consistent rise in operating cash flows over time. Hence, we, as investors, would proceed to check A Bhd’s operating cash flows generated in the last 10 years. If A Bhd had brought in positive and growing operating cash flows in that period, it is almost certain to us that A Bhd is indeed a gem to be kept by dividend investors.
Now, here is a question.
What if A Bhd has a track record of rising earnings and DPS, but not operating cash flows, in the 10 years? Is A Bhd still investible?
The answer is no.
This is because cash flow is king for stock investors.
If a stock (business) reports consistent rise in profits but without cash flow, how would it pay out to its shareholders continuous rise in dividends?
Are these dividends paid out of cash generated from their businesses or through debt or equity?
If a company needs to continuously borrow or raise money from investors to pay dividends, that is unsustainable. Chances are, it would flop and this would be detrimental to investors, who invested into its shares.
4. Valuation: Average Dividend Yields
A stock that is offering a 6% dividend yield doesn’t necessarily mean that it’s either undervalued or overvalued.
To find out, we can calculate the long-term average dividend yield of a stock and compare this to its current dividend yield.
Take A Bhd as an example.
Let’s assume its current dividend yield is 6%.
So, if A Bhd’s long-term (10 years) dividend yield average is 5%, A Bhd is viewed to be undervalued as its current dividend yield of 6% is higher. But, if its long-term dividend yield average is 7%, then it is overpriced as its current dividend yield of 6% is lower. If the long-term average is around 6%, this means that A Bhd’s stock price is currently fairly valued.
Conclusion: Don’t Be Deceived by High Yields
In short, investors should look beyond high yields before investing in dividend stocks. Ultimately, it’s the business model that determines if a stock can generate consistent rise in revenues, profits and operating cash flows, which in turn, sustain and grow its dividends over the long-term. Thus, for all investors, Step #1 in dividend investing is to assess the business quality of a stock. Step #2 is for us to calculate its valuation before deciding if a stock is suitable to be invested and kept over time.
In closing, here is a quick link to a FREE webinar session for you if you are looking to explore how to up your game in dividend investing:
- How to build a dividend stock portfolio that delivers steady cash flow.
- Why yield keeps increasing over time based on cost.
- Simple, proven strategies to make money from stocks—without gambling on market movements.
