05 Apr A Smart Guide to Investing: Dividend Investing
We hope that our previous guide on the difference between growth and income investing was helpful.
Now that you have a better understanding of each, it’s time to drill a bit deeper into a favourite topic of many investors in Singapore: dividend investing.
Why is dividend investing attractive?
Imagine being able to sit back, relax and yet have a steady stream of cash flowing into your bank account.
That’s what dividend investing can achieve for you.
By investing in dividend-paying companies, you are effectively creating a stream of passive income for yourself.
These dividends can double up as a supplement to your regular day job (if you are a working individual), or act as your main source of income in your golden years.
Dividends act as a secondary inflow of cash that you can use for a variety of purposes, hence their appeal.
Key terms explained
What is a dividend? In essence, a dividend represents a payment declared by a company to its shareholders out of the profits earned by the business.
Investors should note that this payment is discretionary (i.e. voluntary) and that the company is under no obligation to declare a dividend.
Bonds, on the other hand, are contractual agreements whereby businesses have a legal obligation to pay out a coupon at regular intervals.
The next question is how much of the company’s profits are paid out as a dividend.
This is measured by the dividend payout ratio (POR).
If this ratio is high, it means that the company is keeping less of its profits to reinvesting in its business.
Most dividend-paying businesses pay out a range of between 30% to 60% of their earnings.
Next up, the dividend yield represents the return you receive on the amount that you invested in the company.
Say you invested $1,000 to buy shares in a company that pays out a $50 a year dividend. Your dividend yield would thus be 5% ($50 divided by $1,000).
Naturally, a higher dividend yield is more attractive.
But investors need to be wary of the sustainability of these dividends.
Finally, on the frequency of payments, some businesses, such as real estate investment trusts or REITs, pay out dividends quarterly.
Most companies declare either half-yearly or annual dividends.
Dividend companies are normally found in mature, stable industries that generate copious amounts of cash flow.
As these businesses generate healthy and consistent cash flows, dividend payments are also predictable and constant.
Most of these companies are in industries that may see slow or no growth in the future.
Examples of such industries include consumer goods, REITs, utilities, industrial goods, telecommunication companies and food and beverage.
As REITs are a separate asset class on their own, we will be providing a guide for it in due course.
Steady dividend payers
Companies that have been paying consistently increasing dividends include 3M (NYSE: MMM), Coca-Cola (NYSE: KO), Proctor and Gamble (NYSE: PG), Hormel Foods (NYSE: HRL) and McDonald’s (NYSE: MCD).
The companies above have paid rising dividends for more than 40 years.
Back home, companies such as VICOM Limited (SGX: WJP), Boustead Singapore Limited (SGX: F9D), Micro-Mechanics (Holdings) Limited (SGX: 5DD) and Singapore Exchange Limited (SGX: S68) are also consistent dividend payers.
These local companies have continued paying dividends even through the global financial crisis and the current COVID-19 pandemic.
The tax advantage
Yet another attractive feature of dividends is that they are tax-exempt in Singapore.
All Singapore-sourced dividends are not taxed, meaning that you will not have to worry about paying income taxes on dividends received.
However, do note that foreign-sourced dividends (i.e. those from companies listed on overseas stock exchanges) may be subject to taxes in their relevant jurisdictions.
For instance, dividends from US-based companies incur a 30% withholding tax.
Contrast this with another popular source of income for Singaporeans: income from renting out their properties.
Unlike dividends, rental income is taxable and needs to be declared to the tax authorities.
The power of compounding
We would be remiss if we didn’t mention one of the best parts of dividend investing.
If you reinvest your dividends back into the same companies that paid them out, you can harness the awesome power of compounding.
Compounding is a virtuous cycle where dividend payments are used to purchase shares in the same dividend-paying companies.
As your stake grows over time, dividends you receive will also increase in tandem.
In turn, these higher dividends are then continually reinvested back again.
Over years and decades, this process builds up an increasing stream of passive income that you can enjoy into your retirement years.
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Disclaimer: Royston Yang owns shares in VICOM Limited, Boustead Singapore Limited, Micro-Mechanics (Holdings) Ltd and Singapore Exchange Limited.