Last Updated on Feb 8, 2022 by Manonmayi
Dividend investing is a strategy where you invest in stocks that pay a regular dividend. This is done to receive a consistent flow of funds that work as passive income. The best part? This income is above and over any appreciation in the stock value. So you can invest in stocks that are growing and benefit from the increase in their worth. At the same time, you enjoy a part of the company’s profit just because you are a shareholder.
Let us explore this strategy in further detail.
This article covers:
- Reinvesting dividend: Cash vs stock dividend
- When do companies pay dividends?
- How to analyse the dividend distribution by companies?
- Dividend payout ratio
- Dividend investing strategies: High yield vs high growth
Reinvesting dividend: Cash vs stock dividend
Companies can either pay cash or stock as dividends. As the name suggests, cash dividends are given to the shareholders in cash. It is credited to their accounts and serves as a source of income. It is a more popular choice among investors as they receive regular rewards. It also has a lower risk (of default on the promise) as the payout is readily received in cash. However, note that dividends are not a compulsion for companies to payout. They may choose to reinvest the profits entirely in the business and not declare dividends at all. Dividends are rather a kind of reward that companies give out to their shareholders.
On the same lines, additional stocks are provided to shareholders on the declaration of a stock dividend. This way, the shareholders hold more valuable shares, and the profit is reinvested in the company. The shareholders have faith in the growth ability of the company. It reflects an appreciation in the shareholder’s portfolio in the long run. But, this option includes higher risk. In case the stock price falls, you lose out on the profit you could have made had you taken the cash payout or sold out earlier.
However, higher risk also improves the chances of higher returns. Cash dividends increase your holdings in a growing firm. If the stock prices rise (which is a high possibility over the long term), you will be richer than if you took an earlier cash dividend.
Different companies have different criteria for declaring dividends. You must research the kind and also the trend of dividend payments.
When do companies pay dividends?
It is ultimately the decision of the company to pay dividends or not. A company may start paying dividends after years of not doing so. A company may also stop or reduce dividends, although it is a rare case as it is seen as reflecting poorly on the reputation of the company.
There may be two situations, though. One is where the company sees many growth opportunities in the immediate future. In such a case, the company does not prefer distributing dividends. Instead, it reinvests its profits for the development and expansion of the organisation. It may possibly declare a stock dividend in such cases if the management deems it fit. Investors that seek a long-term gain in the form of appreciation of stock prices tend to prefer this, though it really is not up to them as to what they receive.
The other case is where the company wishes to reward its shareholders. It shares the profits earned by way of regular cash dividends. Investors who rely on dividends as a regular means of income prefer such companies.
How to analyse the dividend distribution by companies?
The history of dividend payments is a good indicator of which companies are regular with the distribution. In general, a company would not have a fluctuating dividend policy as it builds a negative reputation. If a company declares a dividend in a particular year, it is likely to maintain the same in the years to come. In fact, any increase in the dividend amount is also deliberated with caution. This is because if a company increases the amount but cannot keep up with it in the future, the stock suffers the consequences. Lowering the dividend amount in the future is not seen as the best move.
As an investor, you can look at the history of dividends declared by the company. There are high chances that this will remain more or less similar.
Dividend yield is the financial ratio that indicates how much the company has paid out in dividends in relation to its share price. It is calculated as follows:
Dividend yield = Total dividend per share / Stock price
For example, assume the price of a share is Rs. 100. The company declares a dividend of Rs. 12 for the year. This implies that the dividend yield will be 8.33%.
The result is shown in percentage terms. This makes it easier for shareholders to calculate the return they are getting on every rupee invested. However, it is also advised to convert the figure into absolute terms for better understanding. This is because the denominator is the price of the share, which can make the percentage figure misleading.
For instance, if a company promises a 5% dividend yield with a share price of Rs. 2,000, you get Rs. 100 as a dividend. However, a company with a share price of Rs. 500 can offer a 10% dividend yield, but you will receive only Rs. 50 as a dividend.
Dividend payout ratio
The dividend payout ratio shows the percentage of the earnings that a company pays as a dividend. It is calculated as follows:
Dividend payout ratio = Dividend per share / Earning per share
When analysing a stock, you must look at the trend of this ratio over the years. A stable dividend payout ratio with an increasing trend indicates good financial performance. It also increases the investors’ trust who look for regular dividend payments.
Dividend investing strategies: High yield vs high growth
Investors looking for cash dividends tend to follow the high yield approach. They look for companies that have a large cash flow yet unrushed growth. Such stocks help them attain steady cash flows.
As for a high growth approach, the investors do not earn immediate cash dividends. The stocks they invest in are companies with many opportunities on the horizon. Due to this, they reinvest the profits for development. Investors looking at long-term growth follow this route.
The bottom line
Dividend investing is a great way to supplement your income. Cash dividends are the more popular option among investors as they involve less risk and an immediate money supply. Stock dividends, though less sought-after, have innumerable long-term benefits. Despite the difference in what the dividend looks like, it is an addition to your wealth. This makes dividend investing a great strategy while navigating through the stock market. Regularly read the dividend announcements of companies to stay abrushed.