Not every investor wants thrilling rallies. Many, especially retirees and conservative savers, prefer a steady stream of income that arrives regardless of daily market noise. Dividend-paying companies can provide precisely that. When studying the BSE Share Price of a mature, cash-rich company, the dividend yield becomes a key piece of information. Equally, the NSE Share Price of a utility or consumer major may attract buyers mainly because of regular payouts. This article explains how to build a dividend-focused portfolio sensibly and avoid the traps that await the unwary.
Understanding Dividend Yield and Payout
Dividend yield is calculated as the annual dividend per share divided by the current price, expressed as a percentage. So, a yield of three per cent means that for every hundred rupees invested, you get three rupees every year as a dividend. The payout ratio indicates the proportion of profit paid out as dividends. Moderately high payout ratios (30-60%) are generally healthy. Extremely high payout ratios could be risky if the company faces challenges.
Beware of the Yield Trap
A high yield can sometimes be a trap, so beware of a much higher yield than usual in a stock. In cases where the share price has nose-dived due to deteriorating prospects, while the yield looks tempting, the dividend could be slashed in the near future. Always examine whether the company has consistent free cash flow, rising debt levels and whether profits have been stable. A company that has consistently paid and increased dividends for the last decade makes for a far better investment than one that has made a one-time effort to allure buyers.
Sectors/Characteristics to Favour
Mature sectors with consistent cash flows tend to be good dividend payers. Look at fast-moving consumer goods, IT software firms, power utility and distribution companies, mining firms and some public sector companies. These typically require low capital outlays to finance their operations and carry a conservative balance sheet. Growth companies on the other hand, tend to plough back a hefty portion of their profits into expansion, thus reducing the size of their dividends. This is not necessarily a bad sign, if the returns on investment are high. A balanced portfolio should include a good mix of dividend payers and growth stocks.
Taxes, Reinvestment and Planning
Dividends are taxable in the hands of the investor, based on his/her tax bracket. This needs to be taken into account while calculating yields, especially for the wealthy investor. The reinvestment of dividends back into buying more shares is an excellent way to compound your gains. Investors who don’t need the dividend income can go for this option. For the retired investor who needs the dividend income to meet expenses, regular payouts in the form of cheques can be arranged, so that the income can be budgeted for.
Diversification is vital. It is best not to put too many eggs in one basket, even when shopping around for good yields. Pick around 8-10 companies and stick to them for a few years. Dividend payers mutual funds and index funds focused on high yield stocks can also be explored by investors who don’t want to do the homework on individual companies. Remember that dividends can be volatile and cash flow from operations can be slashed in bad times, so it makes sense to have an emergency fund and buy adequate life and health insurance as well. The total returns (dividends + appreciation) should be considered before zeroing on one particular stock. Savvy investors who focus on fundamentally sound companies, avoid chasing yields, and wisely reinvest the dividends stand to make more money with a steady income stream in the form of dividends.
