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Dividend yield: What does it say? - Views on News from Equitymaster
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  • Mar 9, 2006

    Dividend yield: What does it say?

    The BSE-Sensex has been hitting record highs day after day since the past few weeks and months. While there have clearly been divided opinions in the markets about the direction of the Indian stock markets in the near-term, we would advise investors to look beyond this as the long-term prospects of the Indian economy continue to remain encouraging. In this backdrop, we take a look at the dividend yield, which is one factor that can be taken into account by an investor before making an investment decision.

    There are basically two ways in which shareholders can earn returns. One is, of course, capital appreciation, where the shareholder earns returns through appreciation of the stock price over a period of time. The other is dividend income. Dividends are a way of rewarding shareholders for staying invested in the company. The profitability of the company is, of course, the major factor that determines the quantum of dividend that it will pay out.

    However, another important factor that determines the dividend payout of a company is the industry in which that company is operating. For example, in growth-oriented industries, companies would rather re-invest their profits into their businesses for future growth, based on their capex requirements. This would be more in the interest of shareholders, as the company is investing for future growth. In such cases, the company might not pay much in terms of dividends, and sometimes may not pay any dividend at all. Thus, this is one factor to keep in mind while investing. On the other hand, companies that are into relatively mature industries, are cash-rich and/or which do not need too much capex to expand, are more likely to pay higher dividends.

    Dividend yield basically means the total dividend paid per share in the previous financial year divided by the current market price. This is also one way of judging the attractiveness of stocks. Benjamin Graham, the guru of Warren Buffett, in his book, 'The Intelligent Investor', judges the attractiveness of stocks by comparing them with the yields on long-term government securities (G-Secs). If the dividend yield on the S&P 500 is below the G-Sec yield, then he considers equities as an asset class to be unattractive, relative to G-Secs, with higher risk as well.

    Putting this in the context of the Indian markets, the Sensex trades at a price-to-earnings (P/E) multiple of around 19 times its trailing 12-month earnings and gives a dividend yield of just 1.3%. This is way below the yield on 10-year G-Secs of 7.3%. What this could signify is that at present, equities, as an asset class, is relatively less attractive than G-Secs in terms of yields. It should also be noted that equities are inherently riskier than G-Secs. Therefore, a point should be noted here that if you invest in G-Secs now, you get a virtually risk-free yield of 7.3%, while if you put your money in equities, you not only pay a higher price due to higher valuations at these levels, but also carry considerably higher risk and get a much lower yield. Of course, this is on a macro level and may not necessarily hold true for certain individual stocks.

    It must be noted that the dividend yield is a sort of 'margin of safety' in the sense that even if the stock does not appreciate by a great deal, the dividend income compensates for that to some extent. However, one must understand that dividend yield is not independent of fundamentals. One must still do a thorough research of the company that one wants to invest in. Dividend yield is an additional safety measure that adds to the comfort levels. A reasonable assumption can be made here that companies that regularly pay dividends are fundamentally strong and cash-rich companies.

    One last point here before the conclusion. It has been observed often in the past history of stockmarkets that when the markets are at the bottom of the cycle, dividend yields on a macro basis are high, and when the cycles turn up, dividend yields take a nosedive. This has been seen in the case of the Sensex as well. In fact, in May 2003, when the current bull market was just about to begin and the market was at much lower levels, the dividend yield was around 3.3%. Now, at all-time highs, this has fallen to just 1.3%. Could this be a sign of a turn in the cycle and stock prices more reasonably reflecting fundamentals? Maybe or maybe not, but certainly a point to think about!



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