How to derive passive income from stocks? July 15, 2021

This article was first published in The Edge on 25 June 2021.

Reproduced by permission of The Edge Publishing Pte Ltd. Copyright © 2021 The Edge Publishing Ptd Ltd. All Rights Reserved Worldwide.

Would you like to own shares in a business that consistently gives you income even in bad times? Are you overwhelmed by stock recommendations in the market and on the Internet?

Fret not. Read on to learn how to select stocks that can give you steadfast passive income through the years.

Dividend stocks are one of the simplest ways for investors to get passive income. Dividends are part of the earnings of a company that are given to shareholders.

Below are six pointers to help you identify businesses that can potentially give you a steady stream of passive income.

Stable net profits margins

A good business is able to earn money consistently. Track this by looking at a company’s net profit margins. A company’s net profit margin is calculated by net profit divided by revenue. By plotting a company’s net profit margins over several years, you will be able to see the margin trend and form an idea of whether its earnings are sustainable.

Dividend history

With stable net profits, businesses can afford to pay consistent dividends. Choose a business that not only earns stable net profits but has a history of consistently rewarding its shareholders with dividends.

In the market, there are stocks known as dividend stocks with a track record of paying regular dividends to shareholders. These are usually well-established and creditworthy companies with strong management teams and consistent earnings growth. Their dividends are most commonly issued as cash distributions at regular intervals such as every quarter, every half a year or every year.

Dividend payout ratio

When businesses pay out dividends, you want to make sure that they are not paying beyond what they can bear. Dividend payout ratios are calculated by dividing annual dividends per share by earnings per share.

Some businesses pay more than 100% of their earnings in a year to shareholders. This is not always appreciated by investors, as cash flowing into the business is less than what is being paid out. The high dividends, therefore, may not be sustainable in the long run. Ensure that the company you choose pays out less than 100%. By doing so, it can use its remaining cash to reinvest in the business for growth or keep it for rainy days.

Stable free cash flow

If you are a dividend investor, pay particular attention to a company’s free cash flow. Earnings are not always a good indicator of dividend sustainability. A company can be profitable but have little cash available for distribution.

As dividends are paid in cash, it is necessary to make sure that the company is generating more than enough free cash to pay dividends.

Free cash flow is the cash available to a company after accounting for cash outflows to support its operations and maintain its capital assets.

Companies with sufficient cash tend to be able to maintain or expand their business as well as pay consistent or growing dividends to shareholders.

Interest coverage ratio

Interest coverage ratio is calculated by dividing EBIT over interest expense.

EBIT refers to earnings before interest and taxes and can be found in the annual reports of companies. As a business borrows money to fund growth, it is required to pay interest on its borrowing. This is an interest expense. A business with solid, consistent earnings is generally able to service its interest payments comfortably.

You may select businesses with interest coverage of 2.5 or more which indicates a company has more than enough cash to pay off its interest.

Type of industry

In good times, consumers are more willing to spend on goods and services such as branded goods or overseas holidays. These boost the revenue of businesses that sell luxurious items or are in the tourism trade.

In bad times, consumers will cut down on their discretionary spending and conserve cash. They will spend only or largely on essentials.

But good times or bad, we all need to buy essential items such as toiletries and food staples. Hence, you may look for companies that supply essentials to invest in.

Putting it altogether

A good example of a business that meets our criteria is Sheng Siong Group. Practically all Singaporeans know about this supermarket operator.

But before we start, please note that this example is for education purpose only and not a call to buy or sell.

Sheng Siong’s grocery stores are scattered over various heartlands in Singapore. It runs the third-largest supermarket chain in Singapore, backed by an extensive distribution network and food-processing and warehousing facilities.

Let us look at how Sheng Siong fares in the six indicators.

Firstly, there is stable net profit margins. As illustrated in Chart 1, Sheng Siong’s net profit margins have been stable. They are, in fact, increasing.

Secondly, the chain pays consistent dividends. As illustrated in Chart 2, dividends per share —which give you passive income — are also rising.

Finally, the dividend payout ratio is less than 100% (see Chart 3).

Sheng Siong shares whatever profits it makes with shareholders within its means.

Its dividend payouts have been below 100%. Another appeal is that as its dividends increase, its payout ratio is decreasing. This signifies that its earnings are increasing at a faster rate.

Sheng Siong is thus able to use its excess cash to grow its business or keep cash reserves for the rainy day. Sheng Siong’s interest coverage ratio meets our criterion of more than 2.5 (see Chart 4). In fact, there were years when Sheng Siong had no interest expenses. It did not have to borrow huge amounts of money to fund or develop its business.

Chart A: Market opening gap

Last but not least, recall that people need to buy groceries and necessities through thick and thin.

During the pandemic last year — which forced many to work and eat at home — Sheng Siong reported bumper earnings. This was thanks to its sales of fresh and chilled produce as well as general merchandise such as toiletries and household products, whose demand skyrocketed.

This brings us to our last indicator, which is non-cyclical industries.

Are you ready for the dive? Now that you have our guide on stock selections for passive income, take action immediately. Look up company annual reports to begin your investing journey!