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Dividend yield: Where it is now?

Dec 31, 2004

There are two kinds of returns from investing in equities i.e. capital appreciation and dividend income. Dividends are theoretically the residual cash that company generates after meeting all its investment and financing needs. However, no company gives away all the free cash flow and retains a part of its profits to fund future growth plans or as a cushion in case of an economic downturn. Dividend yield i.e. dividend in a year divided by the current market price of the company's stock is one important factor investors do keep a tab of for two reasons. One, when the dividend yield is high i.e. above the return on a fixed or savings deposit, the stock becomes an attractive proposition for investment. High dividend yielding stocks are generally those where growth prospects are very slow and companies distribute a larger share of the profits, as they find no opportunity to invest excess cash. Secondly, if the dividend yield is low, then the stock is not a 'value play' in most cases and the price has run up very sharply.

In this context, dividend yield from the index stocks gives a picture of the valuations of the markets. Let's look at the historical dividend yields of the Indian market. The following graph shows that dividend yield of Nifty in last five years.

If one looks at the above graph closely, when the dividend yields were at their peak, the markets were at the bottom and vice versa. When the index is trading at a healthy dividend yield, it is a comfort factor for investors because they would find value at these high levels. The stocks with high dividend yield will provide you with the cash flows in form of returns even if capital appreciation prospects are weak. As a result of this, the downside becomes restricted.

But, one thing to note here is that dividends are real returns and returns from capital appreciation can go away in a day's market crash. The dividends are not dependent on the whims and fancies of the market participants. Dividend stocks may not give extraordinary returns within a short span of time, but they definitely provide some kind of a hedge against the day-to-day volatility.

So, where are we now?

  1. In light of the restructuring by corporates since 1997, corporates are flush with funds at the current juncture. Though capital expenditure to sales ratio will increase from here on i.e. more surplus funds invested towards funding growth, we believe that the dividend paying ability of index stocks will continue to remain strong. This is a positive.

  2. Though the dividend yield of index stocks is falling, there are stocks (say, PSUs) with a healthy dividend yield where investors can invest with a long-term perspective.

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