A post on The Motley Fool inspired us to write about dividend investing in Indian stocks. They say that if a person plans to have a long-term portfolio of 10 stocks, atleast 3 should be good dividend paying stocks.
Companies generally pay dividends when they have stable, predictable cash flows and don’t have troubles covering their dividend obligations. So when you invest in good dividend-paying companies, it can be safely assumed that the chosen company is there for the long run.
A talk on stock dividends generally leads to further discussion on its Current Yield (Ratio of Dividend Paid & Current Market Price in percentage terms). Read more about Current Yields here. We will again take up yields later in the post.
It is important for a long-term investor that when he selects a stock for its dividends, he looks beyond just its current yield. What a stock pays as its current dividend is not as important as its future dividends. It is also important that dividends are sustainable & keep coming year after year.
One interesting concept given in The Motley Fool is about Effective Yield – Dividend Yield measured by referring to the original purchase price. Even if a stock carries a modest yield when you buy it, rapid dividend growth can boost your effective yield very quickly, making it much more attractive.
To indicate the relevance of Effective Yield, we take up Clariant Chemicals (I) Ltd. (BSE Code: 506390), a mid-cap known for generous and increasing dividend payouts.
In April 2007, Clariant paid a dividend of 180% (at a face value of 10). At a then-market price of Rs 300, it translated into a yield of 6%. Come FY 2011 & it paid a total dividend of 100% (Interim) + 200% (Final). This translates into a Current yield (CMP – 650) of 4.6%. But if we calculate the effective Yield (@2007 Purchase Price), we have an effective yield of almost 10%. This effectively means that by means of increasing dividends alone, the stock would be able to pay back the investment in less than 10 years!
So what does dividend investing offer to a Stable Investor?
Dividend Investing can help Stable Investor generate an ever-increasing stream of cash. This cash can then be deployed to buy more such assets and so on…
An important point is that one should not be fooled by high dividend yields. The reason for the high yield may be a sharp fall in market prices or a one-time special dividend payout. It is very important to focus on the sustainability of the business when one is investing solely for dividends. There is no use investing in the business for dividends when the company is not in a position to exist after some time.
The Motley Fool has another insightful post on successful dividend investing that can be found here.
Related Reading: How to Live off Dividend Income in India?