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Dividends serve as a reassurance of the worth of your investments

Dividends serve as a reassurance of the worth of your investments
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First Published: Sun, Aug 23 2009. 10 15 PM IST

Updated: Sun, Aug 23 2009. 10 15 PM IST
Despite the mad rush for new age companies, many investors prefer to invest in dividend-paying old stocks. The reason: Present earnings distributed in the form of dividends look more real than earnings just sitting on balance sheets. Dividends, in a way, make you feel as if you are picking up extra money on the way to your regular cash machine.
But that doesn’t mean that you should completely shut your eyes to non-dividend- paying companies. An upstart company may, in the future, turn out to be another dividend-paying big shot.
Johnny: Let’s try to deal with some of the most commonly raised questions regarding dividend. Can you first explain what exactly a dividend is?
Jinny: A dividend is a payment made by a company to shareholders out of its profits. It is the most common way for a company to share its fruits of success with its owners. In the daily uproar of the stock market, we generally forget that beyond all the hype, a company is worth only what it can earn for its owners. A dividend cheque, now and then, serves as a good reassurance that your investments are worth more than the market noises.
But you should also keep in mind that every company does not pay a dividend. In fact, a company has two options while dealing with its profits—it can either retain the profits for reinvesting them into its business or it can share the profits earned with the shareholders in the form of dividend.
Both options have their own merits. A company reinvesting its profits creates hope of more profits in the future, which might lead to appreciation in its current stock price, whereas a company offering dividend creates a more visible incentive. Cash in hand speaks louder than cash in the books of accounts.
Illustration: Jayachandran / Mint
Johnny: Well, both options for using profits look equally good. But why is it that some companies regularly pay dividends while others don’t?
Jinny: To regularly pay dividend, a company needs to first regularly earn profits. Many companies fail to regularly generate profit so they don’t regularly pay any dividend.
However, many profit-earning companies often do not distribute any dividend. The choice of any company to not distribute dividend depends upon its future growth prospects.
A company in the early stage of its life has all the means to look for new engines of growth. But as the size of a company increases it becomes difficult to discover new growth opportunities.
This kind of situation comes into the life of every company which may find one day that its bank accounts are flush with funds but it can’t find worthwhile investments. So a company which has already attained a big size is more likely to regularly pay you dividend.
Johnny: Are there any parameters we can use to compare the payouts made by different companies?
Jinny: You can always look at the performance of your company by using different ratios. The most common one is the dividend yield, which you can obtain by dividing the amount of dividend paid with the current market price of the stock.
If stock A is paying you a dividend of Rs10 at the current price of Rs100 then the dividend yield is 10%. You can use dividend yields to make comparisons. If dividend from stock B is Rs5 at a current market price of Rs50 then your dividend yield is again 10%. For an investor looking for a dividend yield, both stocks A and B would look equal. But you should also notice the difference.
An equal dividend yield does not mean that you are actually receiving equal amounts of money. Likewise, a higher dividend yield does not mean that you are actually receiving a higher amount of money as a dividend.
A stock with 20% dividend yield can actually turn out to be a stock paying just Rs2 as a dividend with the current market price of the stock at Rs10. Further, a higher dividend yield in itself can’t be taken as a sign of good health of your investment. Sometimes, the dividend yield may be higher due to a depressed stock price.
You need to be careful before jumping to any conclusion. Given a choice, a company always likes to paint a rosy picture. Until recently, companies listed on our stock exchanges used to declare dividend as percentage of the face value of their shares. So a company with shares having a face value of Rs2 could declare a 100% dividend by just paying a Rs2 dividend.
To make numbers look more realistic, stock market regulator Securities and Exchange Board of India (Sebi) has now made it mandatory for companies to declare dividend in terms of the amount paid per share.
So now, you will no longer hear about dividends as lofty percentages of lesser known face values.
Johnny: Well, the companies may declare dividends as they like. I don’t mind as long as the money just keeps rolling in.
What: A company can share its profits with its shareholders in the form of dividend.
Why: Many companies believe that regularly paying dividend serves as a good incentive for shareholders.
How: Dividend yield is calculated by dividing the amount of dividend paid with the current market price of shares.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Aug 23 2009. 10 15 PM IST