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Why looking at the dividend yield is one of the worst things you can do

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Dividend yield is at the heart of many bad decisions

Many poor investment decisions are based off this one metric.

After all, everyone loves dividends. Passive income. Financial freedom.

That’s perfectly understandable.

The only issue is that dividend yield is one of the worst possible valuation metrics you can use.

Is the dividend payment a one off?

The first thing that investors need to watch out for are whether dividend payments are one off or “special dividend payments”.

“Special dividend payments” are normally use to indicate that these dividends are meant to be one off because of a special event.

For example, in the case of Singtel, they IPOed Netlink Trust in 2017 and declared a special dividend.

 

However, if you didn’t know this and bought Netlink Trust on the basis on the dividend yield that year, you would be fooled into thinking that the regular dividend would be 20.5 cents instead of 17.5 cents.

2018 2017 2016 2015 2014
Gross dividend per share [cents] 17.5 17.5 17.5 17.5 16.8
Special dividend per share [cents] 3

Is the dividend sustainable?

The second cardinal sin that investors make is that the buy dividend stocks that are paying out far more than they can.

This is especially true for certain types of stocks which typically pay a high dividend like Telcos.

I’ve touched upon Starhub before, but its a great illustration:

At the end of the day, dividends can only be paid from the free cash flow generated over the long run by the firm.

Three most important words – Margin of Safety

In his book The Intelligent Investor, Benjamin Graham offered three words that captured the essence of how copy trade works tips web site – margin of safety.

You have to go further than buying a business that is generating just enough money to pay its dividends.

You have to have a margin of safety.

For example, if a company wants to pay a dividend of 50 cents a year per share, you want it to generate at least 75 cents  in earnings to cover that dividend payment.

That gives you some room to maneuver in the case they run into unexpected problems (and all businesses eventually do), and leaves cash over for them to re-invest it back into the business.

Singapore banks are a great example

In the case of UOB, you can see that UOB is earning far more money that it is paying out.

2017 2016 2015 2014
Earnings per share $1.99 $1.86 $1.94 $1.98
Dividend per share $1.00 $0.70 $0.90 $0.75
Payout Ratio 50% 38% 46% 38%
2013 2012 2011 2010
Earnings per share $1.84 $1.72 $1.43 $1.70
Dividend per share $0.75 $0.70 $0.60 $0.70
Payout Ratio 41% 41% 42% 41%

The payout ratio is essentially a percentage of how much a firm is paying out of its earning.

The rest of the money is “retained” for it to re-invest back into the business.

Ending thoughts:

We are all tempted by dividend yields but investors need to look past this one metric and combine it with other valuation metrics.

In his out of print book, Seth Klarman wrote in Marin of Safety

“There are countless example of investor greed in recent financial history. Few, however, were as relentless as the decade-long “reach for yield” of the 1980s.”

As the saying goes:

“Bulls make money, bears make money, pigs get slaughtered.”

“Yield pigs” was a term coined for investors who bought investment products who offered a high yield, without assessing the underlying product itself.

Don’t be a yield pig.


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