Dividend from shares has attracted many investors into stock markets for decades. It was earlier one of the primary reasons for an investment in the shares of a company. As per the Companies Act, 2013, paying dividends is not mandatory for a company. However, when a company pays dividends it increases the investors’ confidence in the company and can attract more investment. Such dividend paying stocks are quite popular among investors.
Given below are the meaning and a few related details of such dividend paying stocks.
What are dividend paying stocks?
Companies that pay regular dividends to their shareholders are known as dividend paying stocks. These stocks are usually companies that have strong fundamentals and a good business model with ample growth prospects. Such companies are usually market leaders and pioneers in the industry. Such companies pay dividends at a higher rate or and more consistently. Investing in high dividend paying stocks can be in line with the value investing strategy.
What are the different concepts to understand while buying dividend paying stocks?
To understand the true meaning of dividend paying stocks, it is important to understand a few concepts first. Some of the basic concepts are mentioned below.
The dividend is the share of a company’s profits that are distributed to the shareholders. The Companies Act, 2013 has laid down specific rules with respect to the declaration and distribution of the company profits in the form of dividends. Companies have to abide by these rules to ensure that the dividend declared is valid. Dividends can be declared annually, semi-annually, or quarterly.
The dividend yield is the financial ratio that is a comparison between the dividend and the current stock price of the company’s share. The formula to calculate dividend yield is,
Dividend Yield = (Dividend per share / current market price) x 100
3. Ex-dividend date and record date
Most seasoned investors and traders keep a track of the dividends declared by the top companies while making an investment decision. It is important to understand the two main concepts in this regard namely, ex-dividend date and record date. Many investors who target a company after they declare dividends may not know the importance of record date. All the shareholders in the company record as on the record date are eligible to get dividends declared by the company. Ex-dividend date on the other hand is the date usually a day before the record date. If any person buys shares of the company declaring dividends on or after the ex-dividend date, such a shareholder will not be eligible for the dividends.
4. Dividend payout ratio
Dividend payout is another important ratio to be reviewed by investors. It is the ratio of the net income of the company distributed to the shareholders in the form of dividends. A company should have a minimum dividend payout ratio of 40%. At the same time, a company that has a dividend payout ratio of 100% is also not advisable as this will pose a threat to its long-term survival.
What are the factors to check to identify good dividend paying stocks?
Every company at one point or another will provide dividends to its shareholders. It is one of the basic functions of the company. However, in order to distinguish between regular companies and companies that are considered to be good dividend-paying stocks, investors can consider the following points.
1. Regular dividend payment for the past 5 years
A company need not declare dividends every year. However, a company paying regular dividends assured the investors of such a company being financially sound. Hence, investors should consider companies that have consistently been paying dividends for the past five years as a sign of good dividend paying stocks.
2. Minimum required dividend payout ratio
The minimum required dividend payout ratio, as mentioned above, should be 40%. This ensures that the company is using sufficient profits to reinvest in its business and expand growth prospects. Also, a 100% dividend payout ratio will imply that the company is not saving enough as its reserves which can be quite detrimental to the future of the company.
3. Dividend yield more than approximately 3% to 3.5%
The average dividend yield of good dividend paying stocks has to be between 3% to 3.5%. It is the percentage of profits in comparison to the market price that the company is willing to pay each year. It is, however, important to understand that a company having a dividend yield does not necessarily mean it is a good company. It could simply be a way of window dressing the true financial position.
4. Strong fundamentals of the company
The key characteristic of a good dividend paying stock is the strong bones, This refers to the strong fundamental ratios which suggest that the company is better than the industry average and has a good growth avenue.
What are the limitations of dividend paying stocks?
Some of the limitations or misinterpretations of a high dividend paying stock are,
- Investors may perceive a high dividend-paying company to have limited investment opportunities which are translated as higher dividends to the shareholders.
- Dividend paying stocks are usually not growth stocks and therefore often ignored by aggressive investors
- Dividends received from the companies are taxed in the hands of the shareholders at their applicable slab rates. Higher dividends result in higher tax incidence, which can ultimately reduce the benefit of receiving dividends.
Dividend-paying stocks are an excellent investment option for young and risk-averse investors that are new to investment in share markets or want to limit their exposure. These stocks can also help the investors diversify their portfolios and thereby reduce the overall risk of the same.
The basic requirement for investing in dividend-paying stocks is opening a Demat account and having a sufficient investment budget.
The formula for calculating the dividend payout ratio is,
-Dividend payout ratio = Total dividends paid / Net Income
-Dividend payout ratio = 1 – Retention Ratio
Yes. A loss-making company can still declare dividends from the balance in their reserves and surplus account provided they meet all the guidelines set by the Companies Act, 2013 in this regard.
Most investors prefer companies that pay regular and stable dividends rather than in a fluctuating manner. This assures them of the viability of their investment and boosts their confidence in the stable future of the company.