Significance of Dividends on Stock Market Investors

Dividend

A dividend is a payment made by an organisation, to its shareholders from its earnings, mutually decided by the board of directors. When an organisation earns a good amount of profit or has generated accumulated profits over a no of years, it either re-invests the profit in its own business or a new venture which is also known as retained earnings and pays a certain proportion of the profit as dividend to its stakeholders. Distribution of a dividend is generally in the form of cash.

The board of directors can choose to issue dividends over various timeframes and payout rates. Paying of dividends does not fall under company expense but a division of after-tax profits among its shareholders. Companies usually pay dividends on a fixed schedule but may payout a dividend at any time but at times it can also payout a special dividend.

Dividends received in the form of an investment income are currently tax free income for Indian investors in the year they are paid.

Larger, established companies also known as large cap stocks or government owned enterprises with more predictable profits are often the best dividend payers. These companies tend to issue regular dividends as they seek to maximize shareholder wealth in ways aside from the business growth. There are primarily 2 ratios to evaluate high dividend paying companies from around 5600 stocks which are being traded.

Dividend Yield

Dividend yield indicates how much a company pays out in dividends each year relative to its share price. The formula for calculating dividend yield may be represented as follows:

Dividend Yield = Annual dividends per share
                               Price per share

Dividend yield is a way to measure how much cash flow you are getting for each rupee invested in the stock. In the absence of any capital gains, the dividend yield is effectively the return on investment for a stock.

When companies pay high dividends to their shareholders, it can indicate a variety of things about the company, such as that the company might currently be undervalued or that it is attempting to attract investors. Generally, a dividend yield ranging from 3-8% is considered to be a very high dividend paying company from the Indian market perspective.

Dividend Payout Ratio

A dividend payout ratio is the ratio of the total amount of dividends paid out to Earnings per share (EPS) of a company

In simple terms, it is the percentage of earnings paid to shareholders in dividends. The amount that is not paid to shareholders is retained by the company to either pay off debt or to reinvest in other operations.

The dividend payout ratio provides an indication of how much money a company is returning to shareholders versus how much it is keeping to itself to reinvest in growth, pay off debt, or add to cash reserves.

Dividend Payout Ratio = Yearly Dividend per Share
                                              Earnings per share

Several considerations go into calculating the dividend payout ratio, most importantly the company’s level of maturity. A new company that aims to expand, develop new products, and move into new markets is most likely to reinvest all of its earnings and can be ignored for having a low or even zero payout ratio.

In today’s times, companies are extremely reluctant to cut dividends since it can drive the stock price down and reflect poorly on management’s abilities. If a company’s payout ratio is over 20%, it is returning a sizeable amount to shareholders.

However, it is a wrong method to invest in only those companies which pay high dividends. Several other important ratios like P/E, profit growth, ROCE, ROE & Debt-Equity ratio must also be considered while evaluating a company from a long-term perspective.

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