When deciding on investment avenues in equities, most investors think in terms of what income will come only by way of capital appreciation. Seldom do they think that there are a lot of good companies that have been paying handsome dividends annually.
Dividends are payments by a company to its shareholders given out of the profits it makes. It is calculated as a percentage or absolute value per share. Not all companies pay dividends. Some plough it back into business, to generate returns in the future. Others don't pay due to cash flow requirements. But even after having attained scale capabilities, some capital expenditure-intensive companies do not pay dividend or don't pay good dividend, as they have to retain cash for their own requirement. India's largest telecommunication company, Bharti Airtel, had huge capital expenditure in the past few years, so it paid negligible dividends to the shareholders.
In India, dividend income is tax-free in the hand of the recipient or the shareholders. But, companies have to pay dividend distribution tax (DDT), which is 15 per cent, plus applicable surcharge and cess. Suppose a company called ABC has a profit after tax of `50 crore. It has an equity base of `100 crore, divided into 100 million shares of `10 each. Its earnings per share (EPS) will be `5a share.
If it declares a dividend of `2per share, the dividend payout ratio is 40 per cent. If the market price is `100, the dividend yield is two per cent.
Similar is the case for individual stocks, we can compute the dividend yield of an index, say S&P CNX Nifty. The table below provides the movement in priceearnings ratio (P/E), price-to-book-value ratio (P/B) and dividend yield of the S&P CNX Nifty.
The table above clearly shows that in spite of increased valuation of stock in terms of prices, indicated by higher P/E ratio and P/B ratio, the dividend yield is being more or less maintained by companies over a period of time. (The only exception was on March 31, 2009, where there was a drastic reduction in market prices due to a credit crisis in the financial sector.)
Dividend and market price: The history of dividend payment by companies may not have significant influence on stock prices. But, consistent dividend payout may give the company good market standing, as this suggests it has the capacity to earn profits and withstand cash flow uncertainty. Investors are on the lookout for good dividend-paying companies. Such stocks provide stability and investors stand to benefit by way of dividend income if a stock remains below purchase price for a considerable time.
Dividend coverage: This ratio measures the extent to which a company's earnings support its dividend payments. For companies with high dividends, the dividend coverage ratio will be lower as compared to low dividend paying companies.
Dividends and companies: Companies paying good dividend and having good cash flow are more stable, safer and can give an additional income along with capital appreciation to enhance your investment income. However, there may be a decline in dividends when the economy is under strain or the company's profitability is under pressure and it is not sure about its future cash flows. Even during market slowdown, companies that have managed their cash flows well should schemes predominantly invest the majority of their funds in a well-diversified portfolio of companies with relatively high dividend yield, which provides a steady stream of cash flows by way of dividend.
For investors not too well versed in stock selection, dividend yield funds are a better option to invest in. Some of these and their performance are given below: High dividend stocks are good investments for any age group, but it holds particularly true for individuals nearing retirement or ones with irregular income. By careful selection of stocks, you may not only increase your dividend income from them but also capital appreciation if you choose good ones in this category.