Dividend yield is a good story but beware the trap…

The immediate beneficiary of any market correction (probably we can call this a carnage), is the now-famous dividend yield argument. To begin with, it is an extremely logical and seductive argument. Let us explain! Divided yield is obtained by dividing the rupee dividend paid on the stock by the current market price. Obviously, when the prices are falling, the dividend yield tends to become more attractive for that stock. For example, Tata Steel paid a dividend of Rs.8 per share this year. When the stock was quoting at Rs.500/-, the dividend yield was 1.60% (8/500). On the contrary, when the stock had corrected to Rs.200 on August 25th, the dividend yield would have automatically improved to 4% (8/200). Before jumping into the dividend yield argument to identify stocks, one need to understand the following key points to fine tune your decision.

Dividends are tax-free; and that is an added advantage…

It is a well-known fact that the Income Tax Act exempts dividends from tax in the hands of the person receiving the dividend. Effectively a person who buys Tata Steel at the price of Rs.200 would earn an effective dividend yield of 5.71% (4%/0.70); assuming a 30% tax rate. This gives you a quick and simple method of comparing the yield on stocks with the yields on other debt instruments like bonds and fixed deposits (FDs). Remember, this tax adjustment is essential because dividends are tax free in the hands of the recipient, whereas interest on bonds and FDs are not.

Dividend yield acts as a floor price for a stock…

The most credible metrics of valuing an overall market has generally been the dividend yield. In fact, when the dividend yield is combined with the P/E ratio for the market as a whole, it gives a fairly accurate picture of whether the market is overpriced or underpriced. For example at the peak of the market in early 2008, the P/E of the market had gone as high as 28-30 and the dividend yield had fallen to as low as 0.8-0.9. This combination has typically been the point where the froth in the market has tended to unwind.

Focus on the consistency of dividend payout…

Investors may typically wonder, “What is the ideal dividend yield to enter a stock”? Frankly, there are no clear and emphatic answers. For example if a stock gives a dividend yield of 7%, then in pre-tax terms it translates into a dividend yield of 10%. That is an extremely attractive yield. But what is more important is the consistency of dividend yield. Firstly, one needs to ensure that the dividend has been paid consistently over the last 3-4 years. Secondly, you need to adjust for special dividends and one-off dividends. Thirdly, if the company’s dividend shows an uptrend then it is a much better argument for dividend yield based buying.

It is always a dividend yield versus growth trade-off…

At the end of the day, it will be a trade-off between high growth and high dividend yields. Companies that have high growth prospects generally tend to pay lower dividends as the money needs to be reinvested back in the business. Also high growth companies tend to boast of high P/E ratios (pharma and FMCG) and hence the dividend yield argument will largely fall flat in such cases. But above all, one needs to focus on the cyclicality of earnings and larger challenges facing the company. Take the case of steel. Even though their dividend yields may be attractive, steel prices are going through the downside of a super-cycle and hence the argument cannot be used. Secondly, most PSU banks have a high dividend yield because they are required by the governments to pay out high dividends. Here again, the high dividend yield cannot be construed as an investment argument.

What is a better indicator; ROE or dividend yield?

A shareholder earns from a company on two fronts. Firstly, there is the dividend that is paid out by the company on an annual or quarterly basis. Secondly, there is the money that is ploughed back into the business which is instrumental in creating future growth. The Return on equity (ROE) is therefore a more credible measure of shareholder rewards than purely looking at the dividends paid out. That is the reason why over a longer period of time, it is the companies that reinvest more money profitably in the business that tend to outperform the companies that pay out high dividends.

Dividend yield has a role to play as a broad market indicator as also to calibrate a list of stocks that have limited downside risks. However, as an investment argument, the utility of dividend yields is fairly limited!

You can ask us your stock related questions with#AskReligareOnMarkets via our Twitter channel @religareonline

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