Is it possible to get passive income from dividends?

I highly believe and hold firm to my conviction that dividends from stocks is one of the best forms of passive income stream in Malaysia. Hear me out.

Why passive income from dividends is underrated?

I’ve talked about building a passive income stream in my other article. Most other passive income in Malaysia I’ve researched involves a tremendous amount of work upfront and involves specialised skills. Be it from creating content like what I’m doing with my blog, or shooting videos and uploading them on YouTube – all require somewhat a substantial time and effort investment.

Dividends, however, are different. Provided the company you select is really strong and have shown consistent profitability and dividend payout – dividends can be a source of truly passive income. All that’s required is some effort in the beginning to read the companies’ financial reports and some capital to start building your passive nest egg. Most companies pay dividends twice or even every quarter like clockwork. Barring unforeseen circumstances (like the Covid-19 pandemic), many will continue to pay dividends for years to come.

How to make passive income from dividends

In short, to create a passive income stream from dividends require one to buy good companies at great price in order to get a decent dividend yield. Good companies generally means those with a defensible moat, great cashflow generation and above average return on equity. By buying these companies, you’d stand a greater chance of getting more than 4% in dividend yield.

You may ask, but Fiholic, won’t those companies that pay good dividends be too expensive by now?

Yes, you’re right. Investors pay a premium in exchange for consistent cashflow from companies. Many companies with consistent dividend history command a premium in our KLSE. Companies like Nestle, Public Bank and Carlsberg will come to mind. Vast majority are blue-chip counters.

So how to actually buy dividend stocks and ensure your dividend yield will be acceptable? The answer is not so nice to hear:

Patience. Lots of it.

Public Bank once commanded a lofty valuation and was pretty expensive at more than RM20 a pop before the pandemic hit. Now, it has retreated more than 25% from its all-time high. With the loan moratorium and the lowered interest rate, many banks’ stocks have taken a beating.

Seems like a good time to jump into banking stocks now right? Not so fast. Bear in mind that there are no catalyst in the near future that will make banks attractive in the eyes of analysts.

However, when building my passive income machine, I have decided to take a super-long term view of 30 years. Meaning I will hold the stocks that I buy in perpetuity, and I won’t sell, if ever.

So I took the opportunity to add Maybank and Public Bank to my portfolio. Both banks’ valuations have taken a beating and their P/B ratios are below their 10-year average.

Creating a second income stream using dividend stocks

To general principle that I use is quite simple:

1. Company shows consistent EPS growth over the years
2. EPS growth has translated into share price growth
3. Companies’ valuation is attractive now.

How to determine if valuation is attractive? We use simple measures such as P/E, P/B and dividend yields. As long as P/E and P/B ratios are below their long-term averages and DY is higher than the average, it’s a good bet.

The key principle that we hold to here is called reversion to the mean, i.e price will always go back to its mean in the long term.

That being said, nothing is 100% and beware of value traps.