Home / Markets / Stock Markets /  Should you invest in stocks offering high dividends?

The recent announcement of a dividend of 58 per share at Bharat Petroleum Corp. Ltd, a disinvestment candidate for the Centre, excited the stock market. But investors who are enthused by high dividends should factor in a host of metrics. Mint brings you the highs and lows.

How do you know if the dividend is high?

Investors usually compare the dividend to the stock price. The dividend per share divided by the price per share gives you the dividend yield of a company. The dividend yield gives you a rough idea of the income stream you will get by investing in the stock (if the dividend is maintained in future years) and investors often compare it to other income streams such as rent or interest. Note that dividends are declared at the discretion of the firm and there is no contractual obligation behind them like rent or interest. Sometimes, the dividend yield is high because the market is anticipating a fall in earnings and has built it into the stock price.

What does a high dividend yield mean?

Investing in stocks with high dividend yields is popular, particularly among ‘value investors’. A high dividend yield can imply the stock is under-priced and investors can receive steady income even without the stock appreciating. In fact, there’s an entire sub-category of mutual funds called dividend yield funds. However, there are caveats. Companies paying out high dividends typically tend to be mature players in their industries with few alternative avenues to invest the cash. The high dividends can indicate a lack of room or ideas for expansion.

No guarantee of high returns.
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No guarantee of high returns.

What is the tax position on dividends?

Historically, the tax on dividends has been paid by companies through the Dividend Distribution Tax (DDT). This was abolished in the Union Budget 2020-21. From FY21 onwards investors have had to pay a tax on dividends as per their slab rate. Thus, a dividend yield of 10% translates to a post-tax yield of 6.88% for someone in the 30% tax bracket (including cess).

Is there a tax efficient way of investing?

Yes, investing in such companies through mutual funds offers a distinct tax advantage. Mutual funds are structured as trusts and do not pay any tax on the dividends they receive. This dividend is added to the Net Asset Value (NAV) of the fund. Dividend yields funds focus on buying stocks with high dividend yields. If you opt for the growth plan of mutual funds, you do not have to pay tax on this growth in the NAV until you actually redeem your investments in the fund.

What about mutual fund dividends?

Dividends declared by mutual funds are very different from those declared by firms. The former can involve return of your invested capital as well as profits and the Securities and Exchange Board of India has mandated that fund houses refer to them as “income distribution cum capital withdrawals" from 1 April 2021. Mutual Fund dividends are also taxable at your slab rate, making them tax inefficient for high earners. And you cannot predict when the fund will declare such dividends.

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