Sharing Profits

All businesses reinvest their earnings, until such time that they can afford to disburse some of their earnings - Dividends! There are two ways to earn returns from a share: dividend income and capital appreciation. A company that pays a high dividend per share is a good bet, but you need to evaluate the price paid for this dividend. This concept is commonly known as dividend yield. It is calculated by dividing the annual dividend income per share by the prevailing share price. It estimates the current fixed- return potential of your investment assuming that future returns come by way of dividends received. To elucidate its application, consider a company that has been paying a dividend of Rs 2 per share for the past five years. But if the stock price increases from Rs. 50 to Rs. 75 over the five year period, the dividend yield has decreased from 4 per cent to 2.67 per cent, although the quantum of dividend paid remains the same.

On one hand, dividend payments send strong positive signals about the company's financial health. After all, it must be earning profits and generating sufficient cash flows to be able to maintain a steady stream of dividends. And on the other hand, a depressed stock price suggests that it is up for the taking at a bargain price. So the message that you as an investor get is that even though the stock is not doing too well at the moment, but apparently, things are fine at the fundamental level. Usually, high dividend yields are not associated with high growth stocks, but rather with companies which generate steady cash flows but don't have any elaborate expansion plans where they can re-invest the cash they generate. These are usually the companies which have already grown to a sizeable scale of operations. Even though they are earning well and are expected to maintain that in future as well, but there are little possibilities to grow further.

In case of growth stocks, higher valuations are based upon promises of higher earnings in times to come. But if a slowdown occurs, these promises fade away, and suddenly they start appearing expensive. As a result, their prices collapse. During such times, it's the businesses with stable earnings and steady cash flows that offer succour, as they are best equipped to survive through a slowdown. And since they do not command sky-high valuations, they also tend to fall less. Moreover, a steady flow of dividends becomes a vital source of income when there is not much price appreciation to expect. A few indicators to look out for while selecting such stocks are the past dividend paying trend, sustainability of these dividends and a positive operating cash flow that can be gauged by quarterly results. Together with attributes like a low price-to-earnings (PE) and price-to-book (PB) ratios, a high dividend yield makes a sound basis to pick value stocks.