• OUTLOOK ARENA
  • VIEWS ON NEWS
  • JUNE 19, 2009

Dividends, payout ratios and their importance

In the previous article of this series, we had discussed about items that are found at the bottom of the profit and loss account - taxes, net profits and appropriation. In this article, we shall discuss about dividends and its impact on investors.

There are two ways in which an investor can profit from his investment in stocks. One, through stock price appreciation, which we know can remain depressed for a long duration even if the fundamentals of the underlying company are strong enough. Another way to profit from an investment in a stock is through dividends.

Dividends, unlike stock prices, do not depend on the whims and the fancies of the investor community at large. If the business is performing well and generating cash in excess of what is required for growth, dividends are paid out irrespective of the stock price movement.

As mentioned in the earlier article, a company can do two things with the profits that it earns. It can either invest it back into the company (into reserves and surplus) and/or pay out the amount as dividend. As such, dividend payout depends a lot on the cash (after meeting its capital expenditure and working capital requirements) a company generates during a year.

It quite often happens that many companies will not need to reinvest much into the business (in spite of having high return on investments), purely because they don't see the need for it. A classic example would be of companies from the FMCG sector. The FMCG sector is a slow yet steady growing industry. Most of the companies garner high return on their investments in this sector. But yet they choose to pay out huge dividends due to the sector's slow growing nature as capex requirements are on the lower side.

Now if we compare this to say a fast growing industry such as telecom, the situation is quite different. We shall explain this with the help of an example. Telecom major, Bharti Airtel recently announced its maiden dividend of Rs 2 per share. It may be noted that this was after being listed for seven years. The reason for not paying dividends all these years, as attributed by its management, was the huge capital expenditure programme to spread its wings across the entire country.

So, what has made the company announce a dividend this time around? Crossing the peak capex requirement, the management has indicated.

Do all dividend paying companies make a good investment?
The answer is understandably no. This is where the aspect of 'dividend yield' comes into picture. Dividend yield is calculated by dividing the amount paid out as dividend within a year by the company's share price. An example will help in understanding this better.

Assuming a company's stock is trading at a price of Rs 100 and during FY09 it has paid a dividend of Rs 5 per share in total. This stock would be having a dividend yield of 5% at the current price. Assuming that the company is growing steadily and is expected to pay dividends in the coming year, the investor could have surety of earning at least a 5% return on his investment.

However, it may be noted that you should not purely go out and buy a stock which has a high dividend yield. It is very important for you to study the company before deciding to purchase a high dividend yield stock. It could be possible that a company may not be in a position to pay dividends or it might pay lower dividend in the future (as compared to earlier years) due to various reasons an unprecedented loss, higher capex requirements, diversification into newer areas, amongst others.

Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article

Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA, Canada or the European Union countries, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

Equitymaster Agora Research Private Limited (Research Analyst)
103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407