There are many reasons for wanting passive income. A married couple may want passive income so they can go buy something nice for themselves every now and then, a retiree may need passive income to meet his day to day expenses, and an investor may want passive income to deploy into cash generating assets.
Passive income can be generated from real estate properties, a portfolio of bonds, a portfolio of stocks, private businesses and etc. In this 3 part series, I will be talking about the things that an investor should look out for when building a portfolio of stocks for the purpose of generating stable dividend income. In part 1 of the series, I will be talking about the dividend yield as well as something Warren Buffet calls owners' earnings and how that applies to dividend investing. Please also check out part 2 and part 3 (The articles in this series can be read in any order). Here's part I:
Dividend yield and owners' earnings
We first need to start by finding stocks that have healthy dividend yields. We also need to make sure that the dividend is sustainable in the sense that the dividend yield wasn’t inflated by the company paying out a special dividend that isn’t likely to recur, and the dividends paid out as a percentage of owner earnings is manageable.
If the company paid a very high dividend in the previous year because it received a lot of money from selling its assets, profited from its foreign exchange contracts, delivered an extraordinarily large order that’s not likely to recur anytime soon, or because of any other event that has nothing to do with the company’s normal earnings power, then there’s the risk that the dividend will not be sustainable, and investors who bought the stock for its dividend might find that the income they receive from the stock is much less than what they expected.
Warren Buffett came up with the concept of “owners’ earnings.” Owners’ earnings is the cash that the shareholders or owners can take out from a business without affecting the current profitability and competitive position of the business. I believe that measuring the dividends paid out as a percentage of owners’ earnings can give you a much better gauge as to the sustainability of the dividend than measuring the dividends paid out as a percentage of net profit. This is the case as owner earnings take into account the capital expenditure as well as any additional capital that the company has to put up to maintain current profitability and its current competitive position (a lack of capital expenditure will lead to the company’s profitability being impaired, which will lead to dividends being cut as there are less profits to pay out dividends). Net profit might not be a reliable measure of the amount of cash a company can return to shareholders without damaging the earnings power of the business.
To measure the amount of dividends paid to shareholders as a percentage of owner earnings, we first need to calculate the owners’ earnings. Here’s how I calculate owner’s earnings: Net profit (I try and take out one-time gains or losses) + depreciation and amortization +/- certain non-cash items - average capital expenditure needed to maintain current profitability and competitive advantage - increase in working capital (if there is).
After we get the owners’ earnings figure, we just divide the dividends the company paid by the company’s owners’ earnings. This is similar to the dividend payout ratio only that we replaced net income with owners’ earnings. We should look for companies that don’t pay out too high a percentage of owners’ earnings as dividends as this might put the dividend in risk in the event that the company has to invest more money in the business, and if the company choose to forgo investing in the business to maintain the dividend, then it will be worse as the company will be killing itself in the long-run.