Once again, an age-old debate on which is better: Dividends or Growth?
I’m positive many would opt for Growth over Dividends, believing that ‘Growth’ is the bigger money and ‘Dividends’ are smaller. Growth builds one’s net worth. Meanwhile, dividends are often treated as Coffee Money a.k.a ‘Duit Kopi’ in the context of both Malaysians and Singaporeans.
So understandably, many try to ‘time the market’ in order to attain capital gains in the stock market. Most speculate. Some use technical tools. The shared goals are to make more gains faster and as such, they would bring in strong emotions such as fear and greed in the stock market. This explains why the stock prices in the short run can be quite topsy turvy, defying logic and rationality.
To me, that is not my chosen path.
After nearly 10 years of stock studies, I realized that logic and sanity is critical in building and managing a stock portfolio in times of great uncertainties, chaos & confusion. To-date, I have studied 1,000+ stocks’ annual reports and compiled a load of financial data. Of which, I have compared them with their performances in stock prices and discovered a very simple investment principle.
This principle can help you understand how investors could achieve ‘sustainable capital growth’ in the long-term by just simply focusing on ‘dividends’.
Simply put, investing for ‘Dividends’ is also investing for ‘Growth’.
Here, in this article, I would illustrate the power of this principle:
What’s the Logic?
Let’s say, you buy an apartment for investment.
It is a fairly decent unit (fundamentals), which can be rented out for RM 1,000 a month or RM 12,000 a year (income production). You bought the apartment for RM 300,000 (price) as you figured out that it is normal to get 4% in rental yields per annum (valuation) from similar apartment units located in the vicinity.
1. Fundamentals = Fairly decent unit.
2. Income production = RM 1,000 a month or RM 12,000 a year.
3. Price = RM 300,000.
4. Valuation = 4% per annum in rental yield.
Supposedly, you rented this unit out at RM 1,000 a month in Year 1 and 2. Next, you have lifted your monthly rent to RM 1,100 in Year 3-4, RM 1,200 in Year 5-6 and so on and so forth. By Year 11, you’ve successfully raised your monthly rent to RM 1,500 a month or RM 18,000 a year.
The rent raise is doable as it is in line with gradual wage increase at the location (Growth).
So now, what would be the fair price for your apartment unit at Year 11?
Assuming that it is still fair to obtain 4% per year in rental yields, then this unit’s fair price would be calculated as follows:
Thus, Growth in ‘Income Production’ should lead to growth in ‘Asset Prices’ and this holds true as long as the valuation ratio either stays constant or falls.
But if the valuation ratio raises to, let’s say 5% per year in rental yields, then the fair price of your apartment unit would be RM 360,000.
The above is a simple illustration of asset valuation. The principle is widely used by property investors in assessing property deals and being objective on them. I personally believe that this valuation skill is transferable to stock investing. Why is that so? This is because stock investing is about acquiring ‘Income-Productive Businesses’ and holding onto them for the long-term.
Stock Valuation 101
As demonstrated above, investors would focus on 4 things:
2. Income production.
Now let’s say, we have A Ltd, a very profitable business (fundamentals).
In Year 1, A Ltd made $200 million in earnings. Based on 100 million shares, this company’s earnings per share (EPS) would be $2.00. A Ltd had adopted a policy, where it pays out 50% of its annual earnings as dividends to its shareholders. At Year 1, A Ltd paid out $1.00 in dividends per share (DPS) (income production).
You invested in shares of A Ltd at $25.00 a share (price) as you had calculated in detail that its long-term average dividend yield is about 4% a year (valuation).
1. Fundamentals = A very profitable business.
2. Income production = $1.00 in DPS (for the sake of our discussion).
3. Price = $25.00 a share.
4. Valuation = 4% per annum in dividend yields.
Now supposedly, A Ltd has expanded its production capacity, its customer base, its sales, profits, and operating cash flows consistently. As such, A Ltd’s earnings had increased to $220 million in Year 2, $240 million in Year 3, and so on and so forth. In Year 10, it doubled its earnings to $400 million (Growth).
In the 10-year period, A Ltd has maintained its number of ordinary shares and it continued to pay out 50% of its earnings as dividends to shareholders. Hence, it reported $4.00 in EPS and paid out $2.00 in DPS in Year 10.
So, what would be the fair price for each share of A Ltd at Year 10?
Assuming that it is still fair to obtain 4% a year in dividend yields, its fair value is calculated as follows:
So once again, we can see the logic and rationale behind growth in stock prices.
Growth in ‘Income Production’ should lead to Growth in ‘Asset Prices’.
If a stock keeps on growing its business, sales, profits, cash flows and dividends, its stock price should reflect on this continuous growth over the long-term.
Therefore, rather than guessing or predicting where stock prices would move in the short-term, I’ve decided that it is better to focus on the income productivity of a stock (business) over the long-term. If a stock can achieve growth, it should reflect well on its stock price over time.
So once again, is Investing for Growth better than Investing for Dividends?
I would say this.
By focusing on dividend growth, you should over time achieve both Growth and Dividends.
Here, if you wish to learn more on the art of stock investing, here’s a free training you can attend: