Wednesday, February 20, 2008

Book review on "The Ultimate Dividend Playbook" by Josh Peters

Here are my thoughts for the book that I finished reading, titled "The Ultimate Dividend Playbook - Income, Insight and Independence for Today's investor" by Josh Peters. This is another excellent series from Morningstar group. I really really love their clarity and ample use of examples to illustrate the point. This is one of those books that I would love to keep. Probably will buy it, together with another of Morningstar's series, "The five rules for successful stock investing" by Pat Dorsey.

Perhaps it's because I don't have much background in accountings and finance, hence the simplicity of the books drives the points straight home :)

This author is a believer of Graham's teaching, so ample use of margin of safety can be seen in a number of chapters. Like other morningstar series, they place equal emphasis on intrinsic factors like management and economic moat to determine the valuations of dividend counters.

These are the succinct points which I think the author is trying to drive at:

1. Buy and hold for dividend counters. The compounding will work wonders for the patient investor. The author believes firmly in income rather than capital gains because dividend paid out is yours to keep and isn't subjected to the vicissitudes of the market.

2. Prospective returns of a dividend yielding stock = Current dividend yield + Future Dividend growth

For example, if a company has a current dividend yield of 3% and the dividend had been growing in the past for 10%, and we can estimate that in the future the dividend growth is say 7%, then the total returns (prospective returns) = 3% + 7% = 10% for the long term

If one truly understands this, then having a low current yield need not be bad, especially if the dividend growth is higher to give a high total returns. If the current yield is high, perhaps the dividend growth is low, so it brings down the total returns. If the stock price falls, current yield will be pushed up, bring the total prospective returns to be high. It's good to buy when the price is depressed, to put in simply.

Current yield is a function of profits and dividend payout ratio.
Future dividend growth is a function of reinvestment of retained earnings into existing business opportunities, acquisitions and share buybacks.

This, I think, is the gist of the whole book. Truly opened my eyes.

3. Payout ratio = Dividend per share/Earnings per share

High payout ratios leaves little margin for errors since a slight drop in profits might leave the firm with insufficient earnings to cover the dividend. Too low a payout ratio might make the current yield too low to be attractive.

While payout ratio is the amount out of earnings that is paid to shareholders as dividend, what happens to those earnings that aren't paid out (after subtracting costs and such, of course)? It will be plunged back to the firm as growth.

In other words, earnings is either given out to shareholders (rise in current yield) or if not, it'll be plunged back to the firm to grow it (rise in future dividend growth).

4. Sustainable growth rate = (1 - payout rate) x ROE

Sustainable growth rate suggests how much earnings growth can be expected to grow, given constant ROE and payout ratio. Since how much the earnings can grow for a company will in turn affect future dividend growth, sustainable growth rate probable shows us the upper limit of how much dividends can grow. ROE and payout ratio will affect this potential earnings growth.

Given that all else is equal, a firm with high ROE is going to do a better job of increasing its dividend rate than one with lower ROE. And in the long term, ROE is a function of the firm's economic moat.

5. A good check on a firms dividend records can shed a lot of light. These are the points to look out for:

a. Are there dividend cuts? Plenty of cuts means that dividend is not sacred in the company, they shows less commitment by the company to carry on giving the same or more dividends in the future.

b. Is there meaningful payment? Talking about dividend rate here. Check for at least 5 year, 10 years or more if possible.

c. Is there meaningful increment? There must be consistency in increasing dividends. Look for those companies are proud of their dividend increment records - they are less likely to sacrifice these record on a whim. Look for average growth rate too, at least growing faster than the rate of inflation.

6. 3 questions to ask:

a. Is the dividend safe?

b. Will this dividend grow?

c. What is the return?

Each is a separate and wordy chapter on its own, so there is no way for me to summarize it all.

The book ends after teaching the reader how to evaluate the few great dividend plays - banks, utilities, REITS and energy partnership (don't think this is present in Singapore). As I said, an excellent book to start on one's journey into dividend play.

2 comments :

musicwhiz said...

Hi LP,

To put it simply, if a company can utilize its capital efficiently enough to grow its earnings, then I would not mind if it NEVER paid a dividend as the book value of the company will just grow and grow. BRK is one good example, but in reality very few companies are like BRK. Thus, I still do own companies which pay decent dividends ! :P

Regards,
Musicwhiz

la papillion said...

Mw,

Fully agree. I'm a firm believer of capital gains actually, but now my stance had softened. Good to have some income too :)