Dividends: Measuring yields on stock investments

Vasant G Hegde is a former banker, teacher at Manipal Academy of Higher Education, Bengaluru

When you invest your money in financial assets like bank fixed deposits (FD), small savings schemes, debentures, bonds, equity shares, or mutual funds, you receive either interest or dividends. While you receive interest from the issuer which could be a bank, company, or government to the investors, irrespective of whether the issuer makes profits or not, you may receive dividends in the case of shares or mutual funds. Here’s how they work and how you can make your pick based on the promise of their yields.

What are dividends?

Dividends are the distribution of profits by a company to its shareholders. Like companies, mutual funds also declare dividends out of their distributable surplus to their unitholders. The amount of dividend or its percentage and frequency is decided by the company’s board of directors. For a shareholder, there are two benefits. The first is capital appreciation which is the increase in share prices and the second is periodic payments that shareholders receive in the form of dividends. Dividends as we know in India are paid out as cash and credited directly to the bank account of shareholders.

Also Read | All that you wanted to know about perpetual bonds

Why do companies pay dividends?

Companies pay dividends out of the profits that their businesses generate. They pay dividends as a reward to shareholders for contributing to the company’s capital. When they pay dividends, they send out a signal about the prospects of their business. It’s a reassurance to the shareholders that their company is doing fine. Some companies like Tesla or Warren Buffet’s Berkshire Hathaway never declare dividends but instead reinvest them in their business. Companies with good fundamentals declare dividends every year. Some of them may also declare interim dividends or special dividends to keep their shareholders happy.

Why do individuals invest in high dividend-yielding stocks?

Dividends provide a regular stream of income. Dividend investing can be a smart strategy if you can identify companies with a good track record. Dividend yield and dividend pay-out ratio are some of the metrics to identify good dividend-yielding stocks. The dividend yield is arrived at by dividing dividends (in rupees) by the market price of the company’s shares. A higher dividend yield means that the payback period is faster i.e the time taken to recover the initial investment. If the company has paid a dividend of Rs 20 per share and you have paid Rs 500 per share to buy the stock, the dividend yield is 4 and the time taken to recover your investment is 25 years. Of course, a company that is growing will increase the dividend pay-out ratio steadily, reducing your payback period significantly. The market price of a dividend-yielding stock will also keep increasing every year, reflecting the company’s earnings potential.

Also Read | Behavioural biases intaking investment calls

The dividend pay-out ratio is calculated by dividing dividends per share by its EPS (earnings per share). The ideal pay-out ratio is 30 to 40%. While a higher ratio may not be sustainable, a lower pay-out ratio means that the company is reinvesting its profits into its business. To avoid doing all the homework, the easiest way for you would be to invest in dividend-yield mutual funds which invest in high dividend-yielding stocks.

How to receive dividends

Dividends are paid to all shareholders whose name appears in the books of the company on the record date. You don’t need to buy the shares when the company announces the dividends, you can buy them a few days before the record date.

But make sure that the shares are credited to your demat account before the record date. The shares are traded cum dividend till the record date and they become ex-dividend (excluding dividend) after the record date. If a company declares a dividend of Rs 10 per share and you own 500 shares, you will receive Rs 5000 in your bank account. After the record date, the share price will fall by Rs 10.

Taxation of dividends

Prior to March 31 2020, dividends received by an investor up to Rs 10 lakhs were exempt from income tax. The finance bill of 2020 removed the exemption and dividends are now taxed in the hands of the investor.

Dividends are also subject to a TDS of 10% if the amount exceeds Rs 5000 in a financial year. If your annual income is below the exemption limit and you do not want the company to deduct tax, you can submit form 15G or 15H.