Today we’ll be talking about Income Investing. What it is, how it works, examples of income investments and, most importantly, how you can utilise the income investing methodology in order to improve your portfolio performance.
I hope you enjoy reading and, as always, let me know any questions or comments below in the comments section.
Table of Contents
- The 3 main investment types
- What is Income Investing
- A theoretical example
- Important KPIs for Income Investing
- Dividend Yield
- Total Equity
- When to buy and when to sell when Income Investing
- Examples of Income Investing
- How to find opportunities for Income Investing
- 1. Use a stock screener
- 2. Get more information for the stock
- 3. Pull all information together and make an informed investment decision
The 3 main investment types
There are 3 main investment types, which I will elaborate further on this blog: Value Investing, Growth Investing and Income Investing.
All 3 have their place in a well thought after portfolio. There is no best and worst type, but all 3 have the ability to create tremendous returns if done right.
How to distinguish the 3 types, in short, is explained below.
|Investment Type||Value Investing||Growth Investing||Income Investing|
|Methodology||Buy undervalued stocks and sell once back in line with valuation||Buy stocks which are growing tremendously and show no signs of a slowdown||Buy stocks with high dividend yield, so that the quarterly or annual dividend can either be used to re-invest or spent on expenses as a substitute for a regular income (e.g. from a job)|
|Main KPIs||P/E Ratio: the lower the better. Depending on the industry we’re looking at P/E ratios below 20, certainly lower than the industry average)|
P/B Ratio: < 1 (means Market Cap < Total Equity)
P/3Y-H Ratio: > 40% discount of current price vs the 3-year-high price
|Revenue: Rising revenues over the last 3-5 years|
Profit: Rising profits over the last 3-5 years
Total Equity: Rising total equity over the last 3-5 years, means assets increasing and/or liabilities decreasing
Price: Rising share price over the last 3-5 years
|Revenue: Rising or stable revenues over the last 3-5 years|
Profit: Rising or stable profits over the last 3-5 years
Total Equity: Rising or stable total equity over the last 3-5 years, means assets increasing and/or liabilities decreasing
Price: Rising or stable share price over the last 3-5 years
Dividend Yield: Rising or stable dividend yield, typically between 3% and 10%
|Example||Kier Group PLC|
P/E Ratio: 0.97
P/B Ratio: 0.25
P/3Y-H Ratio: -92% (Current Price: 105.9; 3Y High: 1473 (Mar-17) )
|AB Dynamics PLC|
Revenue: Increase from £13.85m (2014) to £37.05m (2018)
Profit: Increase from £2.65m (2014) to £7.88m (2018)
Total Equity: Increase from £10.33m (2014) to £38.04m (2018)
Price: Increase from 168 (Jan-2014) to 2713 (May-19)
|Royal Dutch Shell PLC|
Dividend Yield: 5.5%
Revenue: Stable; £421b (2014); £388b (2018)
Profit: Increase from £19b (2014) to £35b (2018)
Total Equity: Increase from £172b (2014) to £202b (2018)
Price: Stable; 2263 (Jan-2014); 2603 (July-19)
What is Income Investing
The income investor searches for companies which pay a so-called dividend. A dividend is a sum of money which is regularly paid to its shareholders out of the profits the company made since it paid the last dividend. Typically dividends are paid annually, but can also be paid more frequently like bi-annually or quarterly.
Investors can use the dividend as their income, meaning they can go and spend it on their bills. Another popular option amongst investors is to re-invest the dividend payout to steadily increase their portfolio value.
Mostly, only very large corporations with a proven track record of delivering profitable results year after year can afford to pay a dividend to its shareholders. Typical examples are constituents of the FTSE 100 like Royal Dutch Shell, Unilever and HSBC.
The sum of money distributed to the shareholders via the dividend is measured with the KPI Dividend Yield. The dividend yield is a % value and puts the annual dividend in relation to the current share price. The higher the dividend yield the more attractive for the income investor. The dividend yield can start below 1% and can go up as high as 10% or even beyond that. A dividend yield of 10% means, that after 10 years you have received your initial cost of buying the shares back and essentially now holding the assets for free (under the assumption of an unchanged share price and dividend per share over those 10 years).
Royal Dutch Shell, for example, has been paying $1.88 per share every year for the past couple of years. This equates to a dividend yield of between 6.10% and 9.90%, depending on what the share price has been at the time of the dividend payout, as well as the currency conversion rate between USD and GBP. (The dividend is calculated in USD, whilst the share price is calculated in GBP).
A theoretical example
Company A is trading on the stock market for 200.00p, with 100m total shares, that results in a market cap of £200m. The company has a good record of paying high yielding dividends and has paid £0.10 per share every year for the past 5 years, amounting to a dividend yield ranging between 4-6%.
Now, because of the company’s proven track record, investors believe the company continues to pay the same dividend over the next couple of years. An investor buys 100,000 shares of company A for a total sum of £200,000. Going forward, the company pays him an annual dividend of £10,000.
Because of company A outperforming the market, the share price also increases slightly over time. After 5 years, the share price is now 250.00p. The investor now sells his shares, having received not only 5 annual dividends of £10,000 each, but also makes £50,000 profit on selling the shares at a higher price as he bought it. His total profits equal to £100,000 at a 50% return rate on his initial equity.
On the other hand, if the share price of the company was dropping by 20% over the 5 years to 160p, he would lose £40,000 on asset depreciation, but with the dividend payments, he would still net £10,000.
Now, if the investor would re-invest the dividend payment each year, he could buy an additional 5000 shares each year, so at the end of the 5 years, he would hold not 100,000 shares, but 125,000 shares of company A. We assume his average purchasing price is now at 205.00p. If after 5 years the share price is at 250.00p, he would sell for a profit of £56,250. Also, his total dividend payout would increase year over year, because he holds more shares every year and is now equalling to £55,000. Consequently, his total profits are now £111,250 at a 55% return rate on his initial equity. Simply re-investing his dividend payouts made him an additional £11,250.
Important KPIs for Income Investing
In order to find companies suitable for the income investment approach, we need to look at a few fundamental KPIs, which help us to determine whether a company is likely to pay a decent dividend over the next couple of years. The KPIs are similar to the ones discussed in the Growth Investing approach (see the article here in case you missed it), simply because we are generally interested in healthy companies with a potential to grow over time. It’s of no benefit if we find a company paying a high dividend, but is struggling financially. This means the company is likely required to reduce its dividend payout, so we won’t get any income from that company anymore and the share price is likely to tumble as well. This would put us as Income Investors into a loss-making situation, which we obviously want to avoid.
When it comes to income investing, we obviously are most interested in the Dividend Yield. It is calculated as the annual dividend per share divided by the share price. This gives us a % value which typically ranges between 1-10 %, whereas we are interested in companies with a dividend yield of at least 5%. However, we are cautious of very high dividend yields (above 10%), which often indicate a recent major drop in a companies share price and has likely a dividend cut as a result in the near future, meaning we won’t see anything of that high dividend yield actually being paid out to investors.
We can compare the dividend yield across different companies and different industries, which makes it such an easy KPI to look at.
The next KPI we’re looking at is Revenue aka incoming cash flow generated by the company’s sales department.
Important for income investors is to see rising or at least stable revenues over the past 3-5 years. If revenue shows signs of stagnation, but the company is able to keep the dividend payout up, the market is probably at its saturation level, but the company seems to be able to handle that. We want to avoid companies with declining revenues as this will ultimately eat into the required profits for our expected dividend payout.
Third, we’re looking at a company’s profit aka how much of the revenue is left after deducting all costs and potentially interests and taxes, depending on which profit KPI we’re looking at. I usually use the so-called operating profit, also sometimes referred to as EBIT – Earnings Before Interests and Taxes. As interests and taxes can swing widely from year to year, it is better to exclude those from our analysis.
Similar as with revenue, we’re looking for at least stable profits over the past 3-5 years, preferably rising. As the dividend payout is directly derived from the profitability of the company, this KPI is of great importance to us income investors.
Having a single year where the company is struggling with profitability may not directly lead to cutting the dividend payout, because the company can pay the dividend out of cash reserves it has built over the years. However, we want to avoid companies which show a steady decline in profits, as this will ultimately lead to a cut in dividend payouts combined with a dropping share price. A scenario to avoid.
Finally, we like to see that the efforts of the company are paying off in the long term and the generated profits gradually increasing the company’s total equity.
This can be realised in the form of increasing the company’s assets (like properties, inventory or cash) or decreasing liabilities, e.g. by paying off debt facilities.
If a company generates healthy revenues and healthy profits but doesn’t improve its total equity over time, the company might trade on dangerous, short-termed ground and may collapse soon.
Lastly, we look at the company’s share price.
Typically large corporations like the ones we’re looking at with the income investing approach trade in a certain price range over a very long period of time. Sometimes, we don’t see any significant price movements over the course of 3, 5 or even 10 years. For example, the Royal Dutch Share Price was trading in 2011 at the same price as it is trading in 2019. However, the total range over the past 10 years ranges from a low of 1380.00p to a high of 2770.00p. That’s still more than 100% potential growth rate in this range.
For this strategy, it will be vital to assess a suitable share price to buy into the stock and then sit and wait until the share reaches this price to pull the trigger. Good entry points for income stocks are usually after major sell-offs when the price hits levels of past support. That’s when the price typically reverses and steadily increases again over time.
Read more below, how to identify when it is best to buy and when to sell with the income investing methodology.
When to buy and when to sell when Income Investing
Given our indicators, as discussed above, we can build a framework for our income investing methodology. Note, that we don’t necessarily have such a stringent approach here as we have set-up with the Value Investing methodology and it is more similar to the growth investing methodology.
We buy companies with the following set-up:
- Dividend Yield between 5-10 %
- Revenues stable over the past 3-5 years
- Profits stable over the past 3-5 years
- Total Equity stable over the past 3-5 years
- Share Price stable over the past 3-5 years
As income investing is only in part of fundamental nature, I’m bringing a few technical aspects into this methodology.
In order to calculate my target price for a particular company, I estimate the growth rate for the next 12 months to be the average growth rate of the last 3 years. This is my annual extrapolation. Additionally, I look into extrapolating on a quarterly basis. I hereby estimate the growth rate for the next 2 quarters to be the average growth rate of the respective same quarter in the past 3 years.
Finally, I look into broker targets and average those with my annual and quarterly extrapolation values. What remains is my 6-12 month target price for a stock.
In order to avoid buying a company at the top of an uptrend and then having to face potentially larger losses on the following downtrend than I make with the dividend payouts, I try to buy companies which are trading close to a low level of support. This typically happens after major pullbacks or even at the end of a multi-week or -month downtrend.
Once invested, I add to my position whenever the share price comes close to this major support level. So after every downtrend, we have a nice opportunity to add to our investment and re-invest those dividend payouts.
Once the share price rises again away from the support level, we stop adding to our position. If the share price surpasses our target level we prepare to sell and take our profits. However, if the next dividend payout is not too far away it might make sense to wait and hold until the next payout to improve our overall profits with this investment.
Examples of Income Investing
One of the income investments in my current portfolio is Royal Dutch Shell PLC.
In March 2019 we were looking at the following set-up:
- Dividend Yield: 5.5%
- Revenue: Stable; £421b (2014); £388b (2018)
- Profit: Increase from £19b (2014) to £35b (2018)
- Total Equity: Increase from £172b (2014) to £202b (2018)
- Price: Stable; 2263 (Jan-2014); 2603 (July-19)
Our annual extrapolation formula delivers us an estimated annual growth rate of 17%. This averaged out with our quarterly extrapolation, as well with broker targets sets the current target price to 2800 – almost 20% profit potential without the dividend, which comes on top with 5.5%. Our total profit potential is therefore at around 25%.
As the company pays a quarterly dividend I already received my first dividend payout (37p per share in line with past dividends) which was booked in May and the second one has also already booked (again 37p per share) in mid-August for a payout end of September.
At the time of writing this article in August 2019, it looks like the stock price is in a nice downtrend. I will be watching closely and try to snap up some more shares once the downtrend has finished and we’re seeing a rising share price again. It looks like there’s a support level at around 2000p, so I will be watching the area between 2000p and 2050p to add more to my position.
How to find opportunities for Income Investing
Now that you know what income investments are, all you need to know now is, how to find income investment opportunities in the market.
Here’s how I’m scanning the market for opportunities and assessing them accordingly to the discussed methodology.
1. Use a stock screener
While you can use a stock screener to find growth opportunities in the market, it is a bit more difficult here than it is for value investments. I usually scan the market by industry or simply look up stocks I read about in the news or magazines.
The KPIs I’m looking at in the screener are:
- Share Price above 10p (to avoid penny stocks)
- P/E Ratio over 0 (Company has to make profits)
- Dividend per share above 0 (company pays a dividend)
- I order the list descending by Market Cap, to see the largest corporations first as these are most likely to pay a stable dividend
- The second column I take a closer look is yearly performance. A negative performance indicates a recent downtrend, which could present a great buying opportunity
For that purpose, I use the screener from trading view: https://uk.tradingview.com/screener/
There, I built a simple screener showing fundamental data as shown in the screenshot below: Ticker Name, Last Price, Market Cap, P/B Ratio, Yearly Performance, P/E Ratio, Annual Revenue, Number of Employees, Dividend Per Share, Total Shares and Industry.
It is free to use, but you can go Pro, if you want to export the data, have more timeframes available and get the screener to auto-refresh. With the Pro version there are a lot of other benefits as well, see a full breakdown here: uk.tradingview.com/gopro/
2. Get more information for the stock
Once I have discovered a suitable stock in a strong industry, with a promising dividend per share, the next step is to analyse more data. Herefore, I go to Hargreaves Lansdown (HL): hl.co.uk/shares
HL provides a lot of information about a particular stock, amongst others Charts & Performance, News, Broker Forecasts, Financials and Dividends.
For the Income Investing methodology, I’m most interested in the current dividend yield and dividend history. We find the current dividend yield at the top of the first tab and the dividend history in the Dividends tab. We also look at revenues and profits over time, as well as total equity. We find this information on the Financials tab, where I can view annual and interim reports as well as the full balance sheet over the past 5 years. Up-to-date broker forecasts can be viewed in the Broker Forecasts tab.
3. Pull all information together and make an informed investment decision
Finally, we need to pull all the gathered information together to make our informed investment decision.
For this purpose, I developed an Excel tool, which is illustrated in the screenshot below.
I enter the stock I want to analyse into the tool and it automatically pulls the historical performance data as well as current Bid and Ask Price. It also calculates the target growth rate for the current year based on our extrapolation formula. We fill in the collected data, like the broker targets, P/B ratio, Dividend Yield and P/E ratio to complete the data set.
The tool will then calculate the potential for profit if invested at the current price and sold at the target price. As a rule of thumb, I’m currently looking for profit potentials of at least 40% in order to have a large enough margin of safety, in case the investment doesn’t play out as anticipated.
If you are interested in this tool, please contact me on [email protected] or drop me a message on social (see buttons below).
This is how to utilise Income Investing as an Investment Strategy for your Portfolio. I hope you enjoyed reading this article and let me in the comments below if you are utilising this method in your investment portfolio and how this works out for you.
Struggling with your investment returns? Good news! You can now invest in the Dan Schenk Life Investment Trust to truly bring your investment returns to the next level. Or if you rather want to conquer the market yourself, book your free investment consultation below. No payment details needed – no strings attached!