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Investing Basics: A Primer on Dividend Shares

An income stock is a security that pays regular, or even increasing dividends year after year. There is no specific break point for classifying an income stock, but ideally income stocks should provide a relatively high and consistent yield.

Most income stocks are mature companies that do not need to reinvest in the company for growth and can, therefore, use its free cash flow to reward shareholders through dividends. Because of this, it is common to find that most of the returns an investor gets from income stocks are usually from dividends, rather than capital appreciation. However, there are of course, exceptions to the rule, when a company can deliver both high yield and capital appreciation.

In this article, I will breakdown where and how investors can find these gems and what investors should be looking out for in income stocks.

Which industries to look at?

Income stocks can come from any industry but investors can commonly find them in more mature and stable industries such as real estate, energy, telecommunication, transportation and financial institutions.

For instance, real estate investment trusts (REITs) have become an attractive option for income investors due to their high and consistent yield. REITs are required to pay out at least 90% of their distributable income, and therefore, usually have a comparatively higher yield than stocks. In Singapore, the forty-plus REITs currently sport a yield of between 4% and 11%.

Sustainability is key

Besides a high yield, income investors should try to ensure that the security that they are investing is able to sustain its yield. When assessing for sustainability, investors should look at: (1) the company’s historical dividend track record; (2) earnings sustainability or growth; (3) dividend payout ratio; and (4) free cash flow.

The historical track record of a company is an important indicator of its sustainability. If a company has been able to sustain its dividend payout year after year for a reasonable amount of time, it is more likely to do so in the future.

However, as we all know, the past may not always be an accurate indication of the future. Investors should also look at potential earnings growth and sustainability in the years ahead. By looking out for potential earnings catalysts or likely pitfalls, investors can predict if a company’s earnings and subsequently, dividend per share is sustainable in the future.

Thirdly, the dividend payout ratio is a comparison between the dividend per share and the earning per share. A company that is paying a dividend that is higher than its earnings will not be able to sustain its dividend over the long-term.

Finally, a company needs to generate cash to be able to pay out dividends to its shareholders. Investors should try to look for companies that generate enough free cash flow to sustain their dividends.

Can growth and income go hand-in-hand?

Many investors often believe that growth stocks and income stocks are two completely different classes of investment. However, as mentioned earlier, there are exceptions to this rule. A prime example is the American pharmaceutical giant, Johnson & Johnson. The group, which sells a range of consumer goods, medical devices and medicines, is one of just a handful of dividend aristocrats (companies that have increased their dividend for 50 years or more) in the world. Besides its consistently growing dividends, from 1978 till now, Johnson & Johnson’s share price has risen from US$1.84 per share to US$146.87. That’s a staggering 7300% capital appreciation, on top of its increasing dividends. The company, at its current share price, sports a yield of 2.6%.

Closer to home, Ascendas Real Estate Investment Trust (SGX: A17U), the largest industrial REIT in Singapore, was listed in Singapore back in 2002 at a price of S$0.88 per unit. Through strategic use of debt-funded acquisitions, organic portfolio growth and higher rental income, the REIT now trades at S$2.63 per unit. That translates to 298% in capital appreciation, on top of its distribution payout each year. The trust currently has a distribution yield of 5.9%.

The Foolish bottom line

Income stocks provide investors with consistent cash flow and are picked up by those who require cash flow from their investments. As such, investing in them is a perfect strategy for retirees who need the cash flow from their investments to fund their daily lifestyle. By looking out for the four things mentioned earlier, we can sieve out income stocks which can provide both long-term sustainable dividend payouts and dividend growth.

However, income stocks may not just be income-producing vehicles. Good income stocks can deliver both capital appreciation and income growth over time.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned.