Nifty Dividend Yields – A Long Term Analysis of relation between dividend yields and returns

Dividend Yield is a ratio of dividend paid last year to current market price. A further reading on Dividend Yields can be found here.
 
One of the two metrics used to evaluate over- or under-valuation of markets is Dividend Yield (Other is P/E Ratio). At present (Mid January 2012), Nifty has a dividend yield of 1.6 (find latest data here).
 
So is this a right time to invest? We at Stable Investor decided to look into index’s history to answer this question.
 
Analysis of Nifty’s last 13 years data (from 1st Jan 1999 onwards) reveals a few interesting points –
  • Returns during last 13 years, when segregated on basis of Dividend Yields are –
 
  • This clearly indicates that at current Dividend Yield of 1.6, chances of earning around 20% per annum for next 3 years are quite high! (Caution – The statement is made on basis of historical data. Past performance is no guarantee of future performance.)
  • A graph between Dividend Yields and 3-Year-Returns (CAGR) also shows that there is a high (positive) correlation between the two. Higher the dividend yield, higher the returns over 3 year periods.
Dividend Yield & Return Since 1991 [Click to Enlarge]
  • But one must understand that market does not give enough chances at higher levels. Our analysis shows that out of 2500 trading sessions in last 13 years, markets spent less than 5% (127 days) at dividend yields of more than 2.5 (which offers maximum returns over 3 year periods).
Days Spent on various Dividend Yields
 
So after this analysis, Stable Investor understands that though history shows that investing in markets offering high dividend yields makes more sense, one should never rely on just one mathematical tool to arrive at any investment decision. Any number should be taken with a pinch of salt and should always be looked in conjunction with other ratios and numbers.
We did a similar analysis of PE Ratios and Returns over 3 and 5 year periods and arrived at some remarkably useful results which can be found in the post Relation between PE Ratios and Returns.
If you are interested in further exploring slightly advanced topic of Effective Dividend Yield, please read our post on Dividend Investing in Indian Stocks.
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Dividend Investing in Indian Stocks

A poston 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 dividendpaying 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 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 Foolis 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 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 high yield may be a sharp fall in market prices or a one-time special dividend payout. It is very important to focus on sustainability of business when one is investing for dividends. There is no use investing in 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.
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