CA Shefali Mundra
Aspirational investors step into the stock market world to accomplish the dream of accumulating higher returns on investment and wealth creation. 'Buy the dip, sell the rip' is a famous catchphrase often propagated as a strategy for financial success in stock market trading. Although capital appreciation is the primary motive for every investor, a good dividend investing strategy can help establish a steady and reliable stream of income.
A dividend is a distribution of a portion of a company's (publicly-listed companies) net profit to its shareholders. It is typically a cash payout to shareholders or in the form of additional shares on a quarterly or yearly basis.
Dividend Stocks are usually well-established companies consistently distributing their profits as dividends to the shareholders. For instance, ITC is an Indian conglomerate with a diversified presence across various industries such as FMCG, software, hotels, paper boards, agribusiness, and specialty papers. With good growth prospects, ITC has consistently declared dividends for the last five years and is an outstanding dividend stock for investment.
Investment in dividend stocks allows shareholders to benefit from two sources of income, i.e., capital appreciation and dividend payments by the company. Holding stakes in companies with a consistent dividend distribution approach positively impacts the portfolio and provides an opportunity to hedge against market volatility. Additionally, investors can use the dividends to buy more shares and take advantage of dividend reinvestment.
Interestingly, the dividend investing strategy holds exponential power to provide you with a competitive return, irrespective of the decrease or no increase in the share price. For instance, there are two companies, X Ltd and Y Ltd., X Ltd, which pays dividends, and Y Ltd, which doesn't. So, if the stock price of both companies increases by 10%, you gain 10%, and vice-versa you tend to lose if the price decreases by 10%. In this scenario, when X Ltd pays a 5% dividend, you will earn an income of 15% as an investor. If the stock price decreases, then you make a loss of only 5%.
Alternatively, if you have invested in Y Ltd, which doesn't pay dividends, in case of price appreciation of 10%, you gain 10%, but if the price decreases by 10%, then you tend to lose the entire notional gain. Hence, adopting a dividend investing strategy is vital to hedge against market risks.
Getting success with dividend investing is no big deal, but a simple understanding of certain things can help you become a successful dividend investor.
1. Conduct Industry Analysis
Understanding an industry is of immense importance before you decide to invest big bucks in any company. For instance, if you're planning to invest in any pharmaceutical company, government-imposed drug regulations, the status of demand and supply of medicines, and FDA regulations are the things to be pondered upon. This will give investors a bird's eye view of the industry's opportunities, roadblocks, and future growth projections. Industry analysis helps in shortlisting stocks with a consistent dividend approach. Further, you can also sort out the good dividend stocks based on dividend yield, which is the rate of return of dividend.
2. Check Dividend Yield
Dividend Yield is imperative to gain a deeper understanding of stocks and their functioning. It is used to identify the amount of dividend paid by the company to the shareholders in relation to its current stock price. It is a financial ratio generally expressed as a percentage.
Dividend Yield = Annual Dividend per share/Market price per share*100.
For instance, if X Ltd's stock is trading at ₹100 and declares a dividend of ₹15 per share, the stock's dividend yield will be 15%. The higher the dividend yield, the higher the dividend return on investment. Dividend yield can be used as a yardstick for an effective comparison between peers within an industry. Risk-averse investors can look for high-yielding dividend stocks to sustain price fluctuations, maintain a steady source of income, and reinvest to make more money. However, there is always an associated risk, and you should understand that excessively higher dividend yields can indicate declining stock prices. Hence, one should be well-versed with the company's financials, dividend payment history, and market reputation.
3. Be Mindful of the Dividend Payout Ratio
Before investing in the company, you should know the percentage of its net income disbursed as dividends to its shareholders. In response to this, a comprehensive understanding of the Dividend Payout ratio is essential.
Dividend Payout ratio = Total Dividends / Annual Revenue*100
For instance, if X Ltd reports annual revenue of ₹1000 crores and distributes ₹300 crores, then the dividend payout ratio is 300/1000*100=30%.
The dividend payout ratio cannot be considered in isolation. For instance, if the dividend payout ratio is consistently rising, it could be possible that a large portion of the company's net profit is being paid out. Alternatively, a sudden spike could be identified as a step to lure the shareholders into investing in their company. Therefore, you should analyze other factors impacting the company before making the final decision.
4. Invest in Low Debt Stocks
The profitability of the stock is not the only parameter to be considered for investment. It is recommended to go in-depth and choose stocks with high ROE (Return on Equity) and low debt. You can easily capture details of various financial ratios like debt-to-equity and Return on equity in the company's annual reports, or quarterly results. Companies with low debt are highly desirable for dividend investing as they have a lower percentage of interest payments. If a company has more equity and less debt, the chances of interest payments affecting the dividend payment are low.
5. Check Company History
It is highlighted in the article that it is crucial to understand the fundamentals of the company before investing. Besides this, an effective historical performance analysis is crucial to understand the company's overall growth trajectory. Analysis of historical financial performance gives a snapshot of how well the company has dealt with debts and earned revenues. Also, tracking the stock price trends can help avoid substantial capital losses. Although dividend stocks tend to perform well, the historical performance of any company cannot be neglected before investing.
6. Check Tax Implications
In earlier years, when a company declared a dividend, it was responsible for payment of the dividend distribution tax at 17.65%. This implied that the company paid the tax on dividends before they reached the hands of the investors. But, two years ago, a regulatory change was brought about, where the dividend was made taxable in the hands of the investors, applicable as per their individual tax slab. It means that if an individual's income tax slab were 30%, then that investor would be liable to pay a 30% tax on the dividends received in the year. This regulation absolved the companies from paying any tax on dividends but made the investors responsible for the tax payment.
It is also important to note that, for a dividend amount exceeding Rs.5000 from any company, there would be a Tax Deducted at Source (TDS) of 10%, applicable at the time of payment to investors. Depending on an individual's tax slab, when filing their Income Tax Returns (ITR), they could either get a refund of this TDS amount or pay additional tax.
With the right application of the dividend Investing strategy, you can add significant value to your portfolio. The exponential growth is achieved by evaluating and investing in dividend stocks that offer maximum returns while minimizing risk. In adherence to the guidelines laid out here, you are well-positioned to conduct an effective comparison between the companies operating within a similar space and choose the right dividend stock for investment. Understanding tax implications is also essential before deciding to invest in dividend-yielding stocks.
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