Anand and Nandan are long-term equity investors. While Anand is a new-age investor who seeks capital appreciation, Nandan is more traditional and seeks consistent income by way of dividend in addition to capital appreciation in his equity investments. When they met up, the following conversation unfolded:
Anand: Nandan, while I have all along invested in stocks that appreciate in price in the short to medium term, I am now realising that in a volatile market it is safer to look for stocks that pay higher dividend
Nandan: Yes, Anand. Also, as you might be aware, Gujarat Government, last week, tweaked dividend rules and has directed State PSUs to pay minimum dividend at higher of 30 per cent of net profit or 5 per cent of net worth. With this the dividend income from these Gujarat PSU stocks is bound to increase manifold now.
Anand: True, Nandan. So, what are the ratios one needs to look at to identify companies that pay higher dividend?
Nandan: There are two key ratios to track when seeking to invest in the long term.
First one is the dividend pay-out ratio. Higher the dividend pay-out ratio, the better for the investor.
Anand: Can you explain the formula for computing it?
Nandan: Dividend pay-out is the proportion of dividend paid to investors as a percentage of the total post-tax profit. For instance, assume A company earns net profit of ₹100 core. If it distributes ₹30 crore as dividend, then the pay-out ratio will be 30 per cent. If they pay Rs ₹50 crore as dividend, then the dividend pay-out ratio will be 50 per cent. Companies typically determine the pay-out ratio depending on their business plans for the next few years. While companies that have lot of surplus cash share the profits and cash as dividend with investors, some companies use the profits to expand their business either for making additional capital investment or meeting working capital requirement.
Anand: Alright. What are the other ratios to look for?
Nandan: Dividend yield ratio is another important ratio to consider while deciding on a stock. This is basically computed by dividing the per share dividend by the stock price. For instance, if a company B declares dividend of ₹3 per share, and the stock currently trades at ₹60, then the dividend yield ratio is calculated as 3/60x100 = 5 per cent. Higher the yield, the better it is for investors. In other words, you earn a 5 per cent return on the investment, by way of dividend. Fundamentally sound stocks that consistently pay dividend will not only deliver capital appreciation but also dividend income, which will add to your overall return.
Anand: This is helpful Nandan. I now understand why pay-out ratio and dividend yield need to be looked at while identifying stocks for long-term investment.
Nandan: Definitely Anand, happy investing!