‘Money for nothing’ is not only the title of a song by Dire Straits from the ‘80s, it is also the feeling many investors get when they receive a dividend. All you have to do is buy shares in the right company and you’ll receive some of its earnings. How exciting is that? Despite the advantage, however, there are several implications involved in the paying and receiving of dividends that the casual investor may not be aware of. This article will explain several of these. But first, let’s begin with a short primer.
What are dividends?
Dividends are one way in which companies ‘share the wealth’ generated from running the business. They are usually a cash payment, often drawn from earnings, paid to the investors of a company - the shareholders. These are paid annually more commonly, with interim payments. The companies that pay them are usually more stable and established, not ‘fast growers’. Those still in the rapid growth phase of their life cycles tend to retain all the earnings and reinvest them into their businesses.
When a dividend is paid, several things can happen. The first of these is changes to the price of the security and various items tied to it. On the ex-dividend date, the stock price is adjusted downward nearly by the amount of the dividend by the exchange on which the stock trades. For most dividends, this is usually not observed amidst the up and down movements of a normal day’s trading.
The reason for the adjustment is that the amount paid out in dividends no longer belongs to the company and this is reflected by a reduction in the company’s market cap. Instead, it belongs to the individual shareholders. For those purchasing shares after the ex-dividend date, they no longer have a claim to the dividend, so the exchange adjusts the price downward to reflect this fact.
Dividends are generally subject to withholding tax at 10 percent of the gross dividend.
Implications for companies
Dividend payments reduce retained earnings by the total amount of the dividend. The money is transferred to a liability account called dividends payable. This liability is removed when the company actually makes the payment on the dividend payment date, usually a few weeks after the ex-dividend date. For instance, if the dividend was Rs.3 per share and there are 150 million shares outstanding, retained earnings will be reduced by Rs.450 million and that money eventually make its way to the shareholders.
Power of dividend growth
Many investors think of dividend-paying companies as boring, low-return investment opportunities. Compared to high-flying small cap companies, whose volatility can be pretty exciting, dividend-paying stocks are usually more mature and predictable. Though this may be dull for some, the combination of a consistent dividend with an increasing stock price can offer earnings potential powerful enough to get excited about.
High dividend yield
Understanding how to gauge dividend-paying companies can give us some insight into how dividends can pump up your return. A common perception is that a high dividend yield, indicating the dividend pays a fairly high percentage return on the stock price, is the most important measure; however, a yield that is considerably higher than that of other stocks in an industry may indicate not a good dividend but rather a depressed price (dividend yield = annual dividends per share/price per share). The suffering price, in turn, may signal a dividend cut or, worse, the elimination of the dividend.
The important indication of dividend power is not so much a high dividend yield but high company quality, which you can discover through its history of dividends, which should increase over time. If you are a long-term investor, looking for such companies can be very rewarding.
Dividend payout ratio
The dividend payout ratio, the proportion of company earnings allocated to paying dividends, further demonstrates that the source of dividend profitability works in combination with company growth. Therefore, if a company keeps a dividend payout ratio constant, say at 4 percent, but the company grows, that 4 percent begins to represent a larger and larger amount. (For instance, 4 percent of Rs.40, which is Rs.1.60, is higher than 4 percent of Rs.20, which is 80 cents).
Let’s demonstrate with an example: Let’s say you invest Rs.10,000 into XYZ Company by buying 100 shares, each at Rs.100 per share. It’s a well-managed firm that has a P/E ratio of 10 and a payout ratio of 20 percent, which amounts to a dividend of Rs.2 per share. That’s decent, but nothing to write home about since you receive only a measly 2 percent of your investment as dividend.
However, because of great management, the company expands steadily, and after several years, the stock price is around Rs.200. The payout ratio, however, has remained constant at 20 percent and so has the P/E ratio (at 10); therefore, you are now receiving 20 percent of Rs.20 in earnings, or Rs.4 per share. As earnings increase, so does the dividend payment, even though the payout ratio remains constant. Since you paid Rs.100 per share, your effective dividend yield is now 4 percent, up from the original 2 percent.
Now, fast forward a decade: XYZ Company enjoys great success. The stock price keeps appreciating and now sits at Rs.150 after splitting two for one three times.
This means your initial Rs.10,000 investment in 100 shares has grown to 800 shares (200, then 400 and now 800 shares) worth a total of Rs.120,000. If the payout ratio remains the same and we continue to assume a constant P/E of 10, you now receive 20 percent of earnings (Rs.12,000) or Rs.2,400, which is 24 percent of your initial investment! So, even though XYZ’s dividend payout ratio did not change, because of company growth, the dividends alone rendered an excellent return - they drastically increased the total return you got, along with the capital appreciation.
Dividends might not be the most attractive investment strategy out there. But over the long run, using time-tested investment strategies with these ‘boring’ companies can achieve considerable amounts of returns.