How Dividends Play a Key Role in Value Investing?

For a long-term wealth generation form stock markets, Dividends play a key role. However, return from dividends is often overlooked by amateur investors. This article would help you understand how you can benefit from dividend paying stocks and make the most of your deployed capital.

Dividend Definition

Dividends are paid by companies to their loyal shareholders as a way of distributing profits for the financial year. It is often expressed as a fixed value per share, and in rare scenarios as a percentage of face value.

For example, a company may want to pay a dividend of 12.5 per share annually. So, if a person holds 1000 shares of this company, he’ll get 12500.

The dividend amount expressed as a percentage of the stock price is known as Dividend Yield.

The dividend amount may vary each year and its totally up to the company’s discretion whether to pay dividends or not. A company may also pay dividend if is annual profit is low or negative, it depends on the cash reserve in its balance sheet.

Why do Companies pay Dividends?

Listed below are some of the key reasons why companies pay dividends to their shareholders:

1. As a symbol of gratitude to its shareholders so that they remain invested in the company.
2. To increase their reputation among peers. A dividend paying company is often regarded highly as compared to others.
3. Because it cannot stop paying dividends once it started. There is no legal rule as such but if a company suddenly stops paying dividends, it may indicate some financial instability causing the stock price to fall.

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Dividend Cycle

There are 4 important events in the dividend payout cycle:

1. Dividend Declaration Date: The dividend payment is declared during the annual general meeting (AGM). This is where the board of directors meets and decides the dividend amount and payment date.
2. Ex-Dividend Date: The dividend eligibility is evaluated based on the ex-dividend date. Only shareholders who own the stock on or before the ex-dividend date are eligible for the dividend payout.
3. Record Date: The final list of eligible shareholders is recorded on this date. It falls 2 days after the ex-dividend date and a month after the dividend declaration date.
4. Dividend payout date: The dividend amount is finally paid on this date.

How to become eligible for Dividend Payout?

Contrary to the common misconception, you don’t have to be invested in the company for the whole year to profit from dividends.

All you have to do is buy the shares of the company before a fixed “Ex-Dividend Date” and you’ll be counted among eligible shareholders to whom dividends would be paid.

So, for example, if the Ex-Dividend Date is 15^th Aug, and you buy 1000 shares of the company on 14^th Aug, you’ll be eligible for the dividend payout.

Impact of Dividends on Stock Prices

The stock price declines approximately by the dividend amount on the ex-dividend date. The decline is due to the fact that dividend payment causes the money going out of the company’s books

Also, the stock price increases by the dividend amount on the announcement date. So, the overall effect is nullified.

Please note that you cannot buy puts (or sell calls) to benefit from the price decline caused by dividend payout. The intrinsic value of option contracts is already adjusted on the dividend announcement date.

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Dividend Income Illustration

See the below illustration to understand how much returns you can generate from dividends:

Let’s say you decided to invest in a stock before the Ex-Dividend date. The share price is 100 and you buy 1000 quantities. The dividend per share is 10, so you’ll effectively make 10000 (10*1000) on your capital which amounts to 10% return

Now suppose you decided to stay invested in the stock for the next 1 year. In this 1 year, the stock price appreciates to 20%, and the dividend yield increases to 12. So, your net profit % will be the sum of profit from stock price appreciation and dividend income. It would be a 42% net cumulative profit in this case.

Even if the stock price depreciates to 90 in this 1 year and the dividend yield also decreases to 8, you’ll effectively make 7% net profit based on the below illustration:

How to identify the best Dividend paying Stocks?

There is no straight forward formula to find the list of best dividend paying stocks. And, the dividend payout is totally at the discretion of the company, so you cannot predict the dividend amount unless you have some insider sources 😊

Having said that, we have come up with a checklist for you to identify the stocks which may pay good and consistent dividends. See below:

1. Company’s profitability is increasing in the last 5 years
2. EPS (Earning per share) has grown in the last 5 years
3. Dividend per share has grown in the last 5 years
4. EPS grows at the same rate as dividend per share

If a stock satisfies these 4 conditions, then it may be an ideal candidate to buy for dividend income.

Final Thoughts

Dividend income is not one of the ‘get rich quick’ schemes. However, it is very helpful to make consistent long-term wealth from the market. It’s better to park your capital in a reputed dividend paying stock rather than putting it in bank deposits.

Predicting returns from stock appreciation is almost impossible, however, dividend income is more rational and predictable