How to choose high dividend yield stocks?4 min read . Updated: 04 Oct 2020, 02:30 PM IST
- A dividend is an excellent way to earn a steady income through stock investments
- However, not all companies declare high dividends
By Harsh Jain
When investors purchase shares, they become partners to the profits generated by the company via its business. The company can decide to either distribute these profits or reinvest them completely or in part to boost output or expand. The profits distributed to shareholders is called a dividend. This is an excellent way to earn a steady income through stock investments. However, not all companies declare high dividends. Hence, if investors are looking for a steady income source through stocks, then it is imperative that they look for companies that have a history of declaring high dividends. In this article, investors will find some handy tips on how to choose high dividend yield stocks.
What are high dividend yield stocks?
To understand this category of stocks, let’s look at what is ‘dividend yield’.
Dividend yield is a ratio that helps investors understand how much dividend a company pays out each year relative to its stock price. The formula is simple:
Dividend Yield=Annual Dividend ×100 / Share Price
This is an important ratio since it can allow investors to compare companies with respect to their dividend-paying capability. For example, if Company A declares dividends of Rs.200 in one year and Company B declares dividends of Rs.50 in the same year, then which company offers a better return on investment (in terms of dividend)? To understand this, it is important to consider the stock price. Assuming that the stock price of Company A is Rs.2000 per share and Company B is Rs.400 per share, investors can get a better picture by calculating the dividend yields. Therefore,
Dividend Yield of Company A=200 ×100 / 2000 =10%
Dividend Yield of Company B=50 ×100 / 400 =12.5%
Hence, as you can see, while Company A has declared a higher dividend, Company B has a higher dividend yield.
It is important to note that there is no fixed benchmark to define a stock as a high dividend yield stock. This ratio is an excellent way to compare the dividend-paying capability of different companies.
How to choose high dividend yield stocks?
The primary thing that investors must keep in mind is that they should not focus only on the dividend yield to make investment decisions. Since the yield is a ratio of dividends to stock price, if the market price of the share falls, the dividend yield can be high. Investing in such stocks without analyzing the reason behind the drop in the stock price can be counterproductive. Therefore, investors must keep two major factors in mind while choosing high dividend yield stocks:
1) The company must have a history of paying dividends consistently
2) There should be a consistent increase in the dividend yield of the stock every year
These factors can help ensure that companies with high dividend yields are the ones that are performing consistently and growing their business. Here are some metrics that investors must consider while evaluating high dividend yield stocks:
- Dividend yield that is consistently growing over the years.
- A sustainable payout ratio. This is the ratio of the income earned by the company to the annual dividends. So, if a company earns Rs.100 per share as income and pays Rs.40 per share as dividends, then its payout ratio is 40%. This needs to be compared with other companies from the same sector. A lower payout ratio usually indicates the sustainability of dividends.
- Investors can also use the cash dividend payout ratio to supplement the payout ratio while analyzing the sustainability of dividends. This is the percentage of operating cash flows minus capital expenses that the company has paid out as dividends.
- What is the total return since the last dividend payout? Let’s say that a share was trading at Rs.100 after the last dividend payout. A year later, the company declared a dividend of Rs.10 and the stock price increased to Rs.115. Therefore, the total return would be 25% (115 + 10 – 100). This gives a better picture of the returns from the said stock.
- Take a close look at the earnings per share (EPS). This is the profit earned by the company divided by the total number of outstanding shares. It offers a glimpse into the profitability of the company with respect to its shareholders. A company that has a high and consistently increasing dividend yield ratio and a regularly growing EPS is usually considered to be a good buy.
- Lastly, investors must look at the Price to Earnings (P/E) ratio of the company. This can help them understand if the current market price of the stock of the company is overvalued or undervalued. Therefore, they will be in a better position to analyze the dividend yield of the stock.
Investors must always remember that one parameter cannot indicate the strength of a company or its stock. Hence, dividend investors also need to spend some time analyzing the financial strength of the company, its growth path, competitive standing, management efficiency, etc. before investing. High dividend yield stocks can be a great addition to any investor’s portfolio. However, they need to ensure that the company is worth investing in and avoid buying stocks solely on the basis of dividend yield.
(The author is Co-founder and COO, Groww. Views expressed by the author are his own.)