How to Spot a Dividend Paymaster?

When you buy a company's stock you become its part-owner. Being an owner, you deserve a share in the company's profits. It is your reward.

This share of the profit is dividends. The dividend can come to you 1-4 times a year.

The dividend payout frequency may vary from company to company. They may pay every six months or annually or follow a random pattern.

Apart from regular dividends, sometimes a company can issue what's known as a special dividend. Special dividends are a simple way to return the extra money to shareholders every few years.

Occasionally, a company might receive a large cash inflow. It can be due to a large asset sale or supernormal profits or a special company anniversary or some other event. Looking to reward the shareholders, they announce a one-time special dividend.

Last year, BPCL issued a special dividend for its shareholders. Sharing the proceeds from the sale of its Numaligarh Refinery, they announced a special dividend of Rs 50 per share.

This payout was in addition to its annual dividend of Rs 21 per share.

Dividends create passive income

Dividend paying stocks are a favourite with Indian investors. Here's why...

Dividends are a good source of regular income. You feel great once the payout hits your bank account. For investors, it is a classic case of a bird in hand rather than two in the bush.

Dividend paying stocks give out dividends irrespective of the market performance whereas appreciation in the value of the stock usually comes as the broad markets rise. So needless to say, money today (in hand) has more value than the money you will eventually make when the stock price rises.

Take for example, ITC. The company has been paying dividends every year since 2003. While the stock has not risen every year since then, its shareholders got paid during years the stock was down.

Investors did not have to depend on capital gains to make money.

What kind of companies pays dividends?

A dividend paymaster can be defined as a company that has increased its dividend payouts over the years.

Generally, older mature companies are dividend paymasters. Since they run well-established businesses with a strong competitive advantage, they generate more money than needed. Moreover, they have the intention and ability to pay shareholders higher dividends year after year.

Younger businesses need the excess funds to fuel further growth and are usually unable to pay dividends.

Now, this is not unusual. Some of the most successful companies in the world still refuse to pay dividends. Despite being flush with cash, Apple Inc didn't pay dividends for the longest time.

Warren Buffett's Berkshire Hathaway and Google still don't pay dividends to their shareholders.

How to spot a dividend paymaster?

A good way to spot dividend paymasters is to filter companies with a strong history of consistently high levels of these ratios.

Dividend payout ratio: This is calculated as the total dividend paid relative to the net income of the company. It is a good way to judge the dividend-paying capacity of the company.

The key here is to look for consistency. A company with a historically high dividend payout ratio is preferable.

Dividend yield: This ratio shows how much a company pays out in dividends each year relative to its stock price. This helps evaluate the potential profit for every rupee you invest in the stock.

Free cash flow yield: While consistency helps highlight high dividend-paying stocks, you want some consolation that the company won't skip the dividend.

For that, you can evaluate the company's potential to generate free cash flow.

Free cash flow is the money a company has left after paying for capital expenditures, debt repayments, and working capital. This excess cash can be used for dividend payments, share buybacks or inorganic growth, ensuring the company has money.

When you divide a company's annual free cash flow per share by its current share price, you have its free cash flow yield. The higher the number, the better it is. But anything above 5-6% for an Indian company is ideal.

Although effective, keep in mind, these filters are just a good starting point for stock selection and further research.

Dividend paymasters are not always wealth creators

Dividends can add to an investor's wealth with the power of compounding. However, relying entirely on dividend income from stocks without further return expectations can be dangerous. Especially for meeting your long-term financial goals.

While a dividend yield of 3-4% is attractive, it will not allow your investments to grow in line with inflation resulting in a dramatic fall in the value of your initial investment.

Moreover, most companies in their initial period of growth don't pay dividends. They see strong growth opportunities and put back their profits into their own business for expansion.

So, avoiding companies solely because of a lack of dividends can result in you missing out on a great growth story.

Furthermore, unlike developed economies, India is still a growing market. The returns generated by companies in growing economies will be far more superior than most companies in developed economies.

So investing in a growth company that doesn't give out dividends can compensate for the lack thereof.

In conclusion,

Dividend paymasters can provide a steady stream of dividends, acting as an excellent ballast to a portfolio in rocky times.

But if you base your decision to invest entirely on a company's dividend policy, there is a good chance you will be disappointed. No metric on its own can reveal the financial health or future of a company.

The key is to study and look for fundamentally strong companies with great potential. A prudent mix of growth and regular dividends can help you multiply your wealth over the long term.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...