People like capital appreciation more than dividend income. Why? Because dividend yields are smaller. They can be in tune of 1-2%, but capital appreciation are often in double digits.
[Check list of highest dividend paying stocks at the bottom of this post]
But does that make “dividend” less worthy? Not at all.
What comes as a package with capital appreciation is price volatility and associated risk. Predicting capital appreciation is harder. But dividend income is more rational and predictable.
In this article I will explain what makes dividend so special, irrespective of its limitations.
Favour dividend investing for these 4 reasons:
- It’s Different: Dividend focused investing is different. Investors who invest in them does it with a different objective. Their focus is regular income. Even if the yield is low, it’s ok for them. Read more about income investing.
- Visible: Things which are visible, are more predictable. Predictability gives a more sense of control. Likewise, compared to capital appreciation as dividends are more predictable, investors feel more in control.
- Foolproof: If the rules are applied properly, it will not be wrong to say that dividend focused investing is almost foolproof. There are less chances that the investor will make a loss with them. Read more about foolproof investing rules.
- Pros Like it: Champion investors like Warren Buffett love dividend paying stocks. High growth rate is a priority for majority. But expert investors prefer a balanced portfolio. Read about Warren Buffett’s 3 rules.
2. How to generate dividend income?
Buy dividend paying stocks, and hold them for long term. What is the point about ‘long term’? A stock which is yielding 0.5% at the time of purchase, can yield much higher with passage of time. How?
Let’s understand this with a real life example.
Suppose a person bought shares of TCS in year Mar’09. Details are as below:
- Share Price (2009): Rs.132/share.
- No of shares bought: 10 nos.
- Cost paid to buy TCS: Rs.1,320.
- Dividend paid in 2009: Rs.14/share.
- Total dividend income in 2009: Rs.140.
- Dividend yield in 2009: 10.6%.
Suppose this person held on to his shares till year 2018. What will be his dividend yield as on Mar’18? [Note: Bonus shares 1:1 was also issued to all shareholders between Mar’09 & Mar’18]
- Cost paid to buy TCS: Rs.1,320.
- No. of shares held in 2018: 20 nos (1:1 bonus share)
- Dividend paid in 2018: Rs.50/share.
- Total dividend income in 2018: Rs.1,000
- Dividend yield in 2018: 75.7%.
Read more about dividend analysis of TCS stocks here…
Please note how dividend yield improved from year 2009 to 2018. Dividend yield in 2009 was 10.6% compared to 75.7% in 2018.
What is the point?
Just by holding on to “good stocks” for long term (say 10 years), their dividend yield itself will become high enough to beat the returns of any debt instrument.
Is it that easy? Buy dividend paying stocks, hold for long term, and that’s it?Yes it is this easy. The only control point is, one must buy only “good stocks“.
3. Good Dividend Stocks…
Not all stocks that pays dividends are good. There are two criteria which makes a good dividend stock:
- Consistent dividend payout.
- Consistent growth in dividend paid.
This is why companies like TCS and HUL are a good dividend paying stock. They not only pay dividends regularly, but it also grows with time.
Do all companies pay growing-dividends to its shareholders? No. This is why identification of good dividend paying companies is not easy. How to do it? By digging into the financial reports.
4. How to identify them?
What are dividends? Dividends are nothing but a part of companies net profit. A company which make more profits, will pay higher dividends.
Dividend payment is a process by which companies share its net profit with its shareholders. Good company tend to increase its profits over time. As the profits grow, dividend payment by the company also increases.
This is hint which can be used to identify potential dividend stocks. Do the following:
- Step #1: Open the profit and loss account of the company.
- Step #2: Check if the EPS has grown in last 5 years.
- Step #3: Also check if dividend per share has grown in last 5 years.
- Step #4: Compare if EPS growth and dividend per share growth are similar.
[Read more about how to evaluate financial health of a company]
If EPS and ‘dividend per share’ growth are similar, it is a good sign. Why? Because of the following reasons:
- EPS growth means, company’s net profit is improving.
- Dividend per share growth mean, company believes in dividend philosophy.
- EPS growth similar to dividend growth means, as company profit will increase in future, its dividend payout will also improve.
5. Dividend stocks vs fixed deposits
Why I am comparing dividend stocks with fixed deposits? Because starting yield of dividend stocks are even lower than fixed deposits. So some might think that why to invest in dividend stocks?
Good dividend stocks offer two clear benefits to its investors:
- Short term income: Though starting yield of dividend stocks can be low, but it improves with time. Moreover, good stocks can yield very stable dividend income in short term.
- Long Term Gain: There are two types of gains in long term. First, dividend per share will improve hence its dividend yield will also go up. See TCS example shown above. Moreover, there will also price appreciation of these stocks with time.
Though fixed deposits can give fixed interest, but it will never grow with time.
Initial yield of fixed deposit can be better than dividend yield of stocks, but there are some disadvantages as well. Income from fixed deposit is fully taxable. But dividend earned from stocks is tax free (till Rs.10 Lakhs per year).
Example: If you earned a dividend income of say Rs.10,50,000 in a year, you will be taxed only on Rs.50,000 @ flat 10%.
6. There are ‘hold forever’ stocks
Price of dividend paying stocks are very stable. Historically, price of dividend paying stocks waver less than other stocks. They have lower beta. Do you know why?
Because people tend continue to “hold on” to their dividend stocks for longer period of time (sometimes like forever). Why? Because they continue to earn dividend no matter what. There is no need for them to sell their dividend stock holdings.
These stocks tend to yield dividends even during stocks market collapse.
7. How to plan dividend stocks purchase?
How to plan its purchase? By keeping a past record of companies which has paid decent dividends. These will be your list of top dividend paying stocks. (a ready made list is provided above).
Which records are more important than other?
- Net Profit (PAT): This is the profit earned by the company after paying all its dues like adjusting for depreciation, interest, taxes etc. Read more about analysis of profit margin of companies.
- Dividend paid (D): Here we will have to compare two things. Out of the total PAT, how much lump-sum dividend the company has paid. Read more about dividend yield formula.
- Dividend Payout % (D / PAT): Dividend payout suggests, what portion of PAT was paid out as dividend to the shareholders. Record keeping of “dividend payout %” will give a good insight. Good companies try to mimic their past dividend payout ratio.
The above chart is showing a trend of dividend payout ratio for TCS and HUL. What is the trend?
HUL: If HUL will follow this trend, most likely it will give 80% of its PAT as dividend to its shareholders in times to come.
So if we can extrapolate PAT of HUL for next 3-5 years, we will approximately know what can be a potential “dividend income” out of HUL.
TCS: If TCS will follow this trend, most likely it will give 35% of its PAT as dividend to its shareholders in the next years.
8. How else to earn dividends?
In India there are only few avenues to earn dividends: stocks and dividend paying mutual funds.
In Europe and America dividend paying exchange traded funds (ETF’s) are also available. At the moment India do not have such ETF’s.
People can buy stocks using online trading account. These days mutual funds can also be purchased using online trading platforms.
[Read more about REITs. They can also be a good source of dividend income]
9. Limitations of dividend…
If dividend paying stocks are so good, why everyone do not only buy them? Enough of only good things about dividend paying stocks. Here are some limitations of dividend focused investing. I feel, being aware of these limitations will further enhance the benefits of dividend focused investing for the investors…
- High Dividend Yield is not reliable: Dividend yield is not a sufficient indicator to identify good dividend paying stocks. Stocks paying high dividend one year, and nothing the following year, is also not good. It may happen that a stock which is yielding 8% dividend today, may yield only 0.5% in next FY.
- Dividend is high but fundamentals are weak: Few years back Strides Pharma was yielding dividend close to 33% per annum. On Mar’14 it paid dividend of Rs.505 per share. On Mar’18 it paid dividend of only Rs.2 per share. Why it happened? Because EPS of this stock fell from Rs.593 (Mar’14) to Rs.99 (Mar’18).
People who bought this stock then, for dividend yield, must be feeling disappointed today.
Moral of the story: It is important to look at dividend yield, but in conjunction with other fundamentals like sales, profit, EPS, dividend payout %, etc.
Read more about value investing here…
Reinvesting the earned dividends can further increase the yield. People must invest systematically to accumulate dividend stocks. Then the earned dividends from such stocks must be reinvested.
One can think it like this, ‘use the dividend income to buy more “dividend paying stocks‘. Let this cycle to continues for next 10/15 years. This will be a great way of wealth generation.
It is said that Warren Buffett earns billions in dividend alone.
Set a personal target for yourselves. In next five years, let your dividend income reach Rs 5,000/month mark.
List of Top Dividend Paying Stocks in India 2019