Is High Dividend Yield Just a Honey Trap?

It is during a bear market that high Dividend Yield (DY) strategies gain flavor among investors. These investments are based upon the assumption of limited downside risk involved in high DY companies. It is considered that even if the company’s share fails to deliver high relative returns yet the downside risk would be capped by the capital gain through dividends. This article is an attempt to examine whether the above premises hold ground or is it just a trap for investors.

What is Dividend Yield?

Companies often distribute a portion of their profits, in the form of dividends, to its shareholders. The dividend yield is a ratio that expresses the percentage of the quantum of earnings paid to the investors by way of dividends. This ratio comprises dividend per share in the numerator and market price of the share in the denominator and is calculated by the following formula –

As an example, Hindustan Zinc declared a dividend of Rs16.5 in 2020 and its current market price is Rs311. Therefore, its DY will be calculated as follows–

Dividend Yield = (Rs16.5/ Rs311) x 100 = 5.3%

Investors can compare the DY of a company with that of its sectoral average before taking an investment decision.

From Where to Obtain Data About a Company’s Dividend?

Investors would need to look into the annual reports, available on the NSE website, of the company. The information about the dividend paid would be available in the financing section of the cash flow statement. Dividend paid for the last four quarters can also be added to arrive at the dividend paid for the trailing twelve months.

Investors should be careful about the practice of taking a dividend of one quarter and then multiply it by 4 to calculate the annual dividend for the current financial year. The reason being not all companies pay dividends in such an even manner. Many times small quarterly dividends are followed by a large annual payout to the investors. This way the yield figure calculated in the first instance would be deflated and hence incorrect. An investor needs to look for historical data as to how frequently a company distributes dividends and is it paid evenly throughout the year or unevenly.

Some reliable websites and financial magazines can also be used as a ready source of information. Some trading platforms also provide company-specific dividend data.

Is High DY Strategy Good For All Type of Investors?

The high Dividend Yield strategy is suitable for risk-averse investors. It is for those investors who are comfortable with fewer returns but need security in terms of tamed depreciation at share price during market fall. They would like to cushion their loss, during market corrections, with that of dividend yield. Also plowing back gains from the dividends would add to their future profit potential.

On the other hand, a risky investor would not be comfortable with this strategy. He would be looking for companies with high growth in their top-line, bottom-line along with healthy cash flows. In addition to these high growth factors, he might also like to filter high beta stocks so as to cash upon their outperformance in case of a bull run in the market. He would believe that there is potential for higher returns from the growth in value of the stock price compared to the returns from dividends only.

There are some other investors who would like to pocket dividends as a tax-free income. They need to be updated that before 2020, companies deducted Dividend Distribution Tax (DDT) from dividends and pay the rest of the amount to the investors. The investors did not have to pay any tax on this income. But presently there is no DDT on dividends so this income is treated as income from other sources and investors are liable to pay tax on it as per their income tax slab.

Is High DY a Fool-Proof Strategy?

Generally, it is assumed that the Dividend Yield Strategy would work well in a bear phase of the market as it would limit the downside risk for an investor through dividend income. But an investor cannot afford to ignore the fact that investment in equities involves risk. Capital loss due to a sharp decline in share price cannot be fully mitigated through dividends. For example, Coal India paid a total dividend of Rs13.1 in 2018 at the stock price of Rs250. The DY thus came out to be 5.24% but then the stock price has been hovering at around 150 for the last two years. It paid dividends of Rs12 and Rs12.5 in 2019 and 2020. The company happens to be a consistent dividend payer and yet the investors have been sitting on a loss. This is because the stock could not perform with the overall market due to the internal dynamics of its business. In such cases, the investors would require other hedging techniques to reduce the volatility risk in their portfolios.

Also before calculating Dividend Yield investors need to keep in mind that a sharp decline in an equity’s price would lighten the denominator part of the DY formula and hence inflate the Dividend Yield figure. During the unusual price fluctuations, these figures may misguide the investors. In the above example of Coal India, the DY in March 2019 was 5.24% but if it is calculated in February 2020 it will come out to be around 8% due to a sharp decline in price. For that investors need to assess the historical data before arriving at an investment decision. Consistency would be a much sought out key factor in such cases.

It’s important to know from where the company has been generating income, which is being distributed among the investors as dividends. The company might be sharing a part of their net profit with the investors but it could also be the income from the sale of assets etc. Investors need to study the cash flow statements to examine the sources of income (for illustration purposes, refer cash flow statement of Hindustan Zinc below taken from its Annual Report 2019-20).

Some investors would also like to delve into the Dividend Payout Ratio as an alternative to the Dividend Yield as it represents the actual earnings of a company paid to the investors as dividends.

Distributing dividend among investors also means that the company is not going to utilize that part of income for capital expansion. In case the overall economy is in depressed shape, even a consistently high dividend yield company may see a sharp decline in their net profits and hence financially underperform in the near future. That may also hurt their yield for the coming years.

Concluding Remarks

Dividend Yield is a very long-term strategy that is suitable for a specific group of risk-averse investors. They would like to keep high DY companies, with good financial backgrounds, for decades to generate consistent income over a much longer period of time. Therefore, an investor should first explore his/her investment style before following a high DY strategy. High DY strategy works well in mature companies with a good track record of generating decent income and paying dividends to the investors. It is not just the dividend income but the price appreciation of the company’s share that is going to generate wealth for the investor. The new companies do not have such historical data to make an assessment of their future potential and hence miss an edge over the old companies. Investors need to be careful when there is a sharp decline in share prices as it inflates the DY figures to a great extent. Such figures may trap investors for a much longer time. An investment inconsistent dividend-paying companies with healthy growth aspects would set an escape plan from the DY trap.

Disclaimer: The stocks discussed in this article are for illustration purposes only. They should not be considered as an investment or trading advice.