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Dividend as a regular income strategy

5 Mins 22 Feb 2022 0 COMMENT

You must be familiar with one way of making profits in the stock market, which is by purchasing a stock at a cheap valuation, holding it for a while until the market realizes its value and then selling it for a higher valuation if deemed necessary, thereby earning a profit, or in other words, profiting from the capital appreciation of the stock. But there is another way which can make profits and also act as a potential source of income in the long run. It can be done by investing in dividend paying stocks and in this article, we will understand what dividends are and how one can use them as a regular income strategy.

Firstly, let’s understand the basics about dividends

A dividend is essentially a distribution of a part of a company’s earnings, sourced from the net profit generated by the company to its shareholders, as determined by the company’s board of directors.

A company after generating profits accumulates some earnings. A part of these earnings may be paid out to the company’s shareholders as dividends and the other part can be retained and reinvested by the company.

Dividends can also be considered as a profit sharing by publicly-listed companies to their shareholders for putting their money into the company.

Cash dividends are one of the most common ways of paying out dividends, but a company may also issue additional stocks like bonus shares in place of cash.

Dividends are usually issued by profit making companies with the goal of maximizing shareholder wealth. They can be issued over various time-frames along with different pay-out rates as determined by the board of directors.

One thing which needs to be remembered is that a company is not obligated to pay dividends. If a company feels that it is better to redirect these generated profits back into the business for growth and development purposes, as this would help increase stock price and eventually shareholder value over time, it may choose to retain its profits. This is usually the case with companies who are at a growth stage and need this amount to expand and scale up their operations and services.

Dividend pay-outs usually follow a chronological order of events and the dates associated with these events are important as they determine the shareholders who will be eligible for receiving the dividend pay-out. Let’s discuss the important dividend dates which need to be considered one by one.

Firstly, there is the announcement date on which the company’s board of directors announce the decision that they will be paying out dividends.

Secondly, there is the ex-dividend date on which the dividend eligibility expires. As an example, if a company announces that the ex-dividend date for the stock is Wednesday, 11th August, then investors who buy the shares on or after this date WILL NOT be eligible to receive dividends. The investors who bought the shares before the ex-dividend date, say, on Tuesday 10th August, will be eligible to receive dividends.

Thirdly, there is the record date which is a cut-off date used to determine which shareholders are eligible to receive dividends. The record date is usually 1 to 2 days after the ex-dividend date.

And then comes the payment date, which is when the dividend paying company issues the payment which then gets credited into the eligible shareholders’ accounts.

Additional Read: Types of equity trading

Let’s now understand the impact of paying-out dividends on the stock price of the company

Dividend pay-outs do impact the share-price of a company which may rise on the announcement date and then decline by a dividend amount after the ex-dividend date.

When a company announces that it will be paying-out dividends, the demand for the shares of the company may start rising as more investors try to buy the shares in order to earn those dividends, which would then potentially increase the price per share leading up to the ex-dividend date.

Then, when the ex-dividend date comes, the stock price may decline by approximately equal to the dividend amount. However, in the long run, the share price of the company settles based on the stock's fundamental value.

Let’s now take a look at the advantages of investing in dividend paying stocks and how they can act as an additional source of income

A company with strong fundamentals and good prospects may pay dividends regularly, thereby turning into a source of income.

Not only dividends but these share also provide an opportunity for capital gain.

Some investors may use this additional dividend income to reinvest it by purchasing the stocks of the same company issuing it. Doing this increases the number of shares you hold and if the company were to pay out more dividends in the future, you are paid more dividends as a result. On top of this, if the company is fundamentally strong and has solid growth prospects, then it is likely that its profits will increase over the years and may also increase the amount of the dividend. Thus, this pay-out may create a regular stream of income and the share price will also rise over a period.

And as the dividends paid out increase over time, you get the chance of getting a healthy dividend yield on your invested capital. On top of all these, regular dividend pay-outs also act as a reliable tool for stock selection. Consistency in dividend payments reflect the financial soundness and profit-generating capacity of a company as it is highly unlikely for a company to pay dividends if they aren’t generating cash regularly.

Additional Read: Taxation on equity investments

Let’s now understand a few factors which you should consider before investing in dividend paying stocks

Firstly, one needs to ensure that the company has a consistent track record in offering dividends. The concerned company should be paying dividends regularly for the past 5-10 years at least.

Secondly, one should analyse the company as a whole. One should consider the long-term growth prospects of a company to gauge whether the company will be able to survive, grow and increase profits in the long-term. Companies which have a solid track record of enduring economic recessions and bouncing back should be considered.

Thirdly, one must analyse dividend-related parameters like the dividend pay-out ratio and the dividend yield.

The company should preferably have a high and constant dividend pay-out ratio. The dividend pay-out ratio is the proportion of profits the company is paying to the shareholders in the form of dividends and is represented as a percentage. If a company is paying Rs. 40 out of Rs. 100 earnings, it means its dividend pay-out ratio is 40%.

The overall dividend yield should preferably be between 3% to 6%. The dividend yield is expressed as a percentage by dividing the annual dividend amount by the share price. It should be kept in mind that higher dividend yields may not always indicate attractive investment opportunities due to the fact that the dividend yield of a stock may be elevated as a result of declining stock price.  

The bottom line is that one should ideally stay invested in quality stocks and one should also consider diversifying their dividend stock investments over multiple industries and sectors so that one’s dividend income isn’t too dependent on one single sector.

To conclude, let’s summarize everything we discussed:

  • We understood that dividends are a part of the earnings sourced from the profits generated by a company which are paid out to their shareholders.,
  • Then we looked at the important dates associated with a dividend pay-out.
  • We understood the impact of dividend pay-outs on the share price of the company.
  • Then we looked at the advantages offered by dividend stocks and some factors to be considered before investing in dividend stocks.

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