If you try to compile a top 10 or top 20 list of high dividend paying stocks, a lot of the stocks which will find a place in that list will be illiquid or unheard off. You have to avoid such stocks which pay high dividends for anything between 2-4 years with the objective of directing earnings out to the promoters who mostly hold a large percentage of shares in such companies. However, within the sphere of safe large caps, you will find many consistently high dividend paying stocks. Look for below traits before selecting a stock for dividend investing:
► Frequently traded stock (i.e. there are always enough buyers and sellers for the stock) prefer stocks from index fund such as the Nifty 50 or the S&P BSE 100, S&P BSE 200 etc.
► Backed by good solid managements;
► Have well established businesses;
► Consistent with dividend payments – For example, if you take the case of Century Enka, it has consistently paid a dividend between Rs. 5-6 per equity share for the last 10 years including the years 2008 & 2009 when the stock markets crashed by close to 60% from a peak of over 21,000 to below 9,000;
► Finally, look for sustainability of dividend payouts by focusing on companies with a low Dividend Payout Ratio (DPR).
Lets discuss the last point further.
Assessing sustainability of dividend payouts
So what Companies distribute high dividends? And which ones are likely to sustain their dividend payouts?
Before we get to that, let me assure you that buying companies based on high dividend yields could prove to be fatal if done without research and knowledge. Far too often companies maintain a high dividend yield for 3, 5, or even 7-8 years before they completely stop paying dividends and before their share prices collapse. However, with some effort, you can discover companies which are likely to sustain or increase their dividend yields. You can even see signs of a future reduction in the rate of dividend payment far ahead of such happening.
Remember, the company pays dividends out of its profits (i.e. current year profits or accumulated reserves). When profitability declines, sooner or later it will have an impact on the share price and dividend payouts of the company. This is an enduring lesson which markets have taught investors time and again. In reality, once the profitability of the company starts declining, two things happen, usually in this exact order: (1) The company’s share price corrects first; and then, (2) Over time, the company reduces its rate of dividend. Why does it happen in this order? Most often companies try to maintain the same dividend yield even when the profits decline, mostly dipping into their built-up reserves to match previous year’s dividends. This is because companies naturally like to show, and in many cases genuinely believe that any setback in business is temporary and that the business will recover sooner more than later. What can I say, optimism and hope are to a large extent naturally occurring traits of human nature. In most cases where dividend yield is reduced, you will find that it was preceded by a reduction in the growth rate of profitability. For this reason, it is important to keep a close eye on the profitability of the company in addition to its dividend yield. Use our growth evaluator list (link on the right) to view dividend yielding companies which are consistently reporting higher profitability figures. The list also contains 5 of my favorite stocks to hold for dividend investing.
Consistency in dividend payouts and the likelihood of sustained higher dividends in future are critical aspects to keep in mind when investing in a company with a view to earn dividend income. That said, no investment operation is sensible if you ignore the safety aspect and fail to manage the associated risks. What’s the point of buying shares in a company which maintains a dividend yield of 8% but the price of the share of which declines by 10% every year? As I had stated above, companies which pay an extremely high dividend yield may well be just two leaps ahead of the wolf and should be avoided.
So how do you go about finding safe yet high dividend yielding companies? The key ratio to look at when determining the consistency of dividend payouts is the Dividend Payout Ratio.
The Dividend Payout Ratio
The Dividend Payout Ratio (“DPR”) highlights the proportion of the company’s profit which the company pays out as dividend. It is an extremely efficient tool to measure a company’s ability to maintain or grow its dividend yield. The formula for calculating the DPR is:
For example, a company paid interim dividends of Rs. 2 and Rs. 3 and a final dividend of Rs. 5 in a given financial year and its EPS for the same financial year was Rs. 22. Its DPR will be 45.45 % (i.e. (2+3+5)/22*100). You can calculate the DPR for Trailing Twelve Months (TTM) by dividing the dividend declared during the last 4 quarters by the EPS of the last 4 quarters.
Typically, well established large cap companies are market leaders in their sphere and have achieved their desired level of capacity expansion are more likely to return a higher percentage of their profit as dividends. This is because they may not need as much funds for expansion or growth as may be a younger company which is in its growth phase.
So what is a good DPR?
Ideally, companies which have a DPR of over 55% could prove to be risky because in times of economic slowdown or temporary setback to the business, when the profitability of such companies take a hit, they will find it difficult to pay out high dividends.
The best companies are the ones which have a high dividend yield and at the same time have managed to maintain a low DPR. With such companies you can be assured that either their future profitability or their built-up reserves will support a consistent dividend payment even if there are temporary setbacks or slowdowns along the way.
Allahabad Bank – CASE STUDY
Over the last 10 years Allahabad Bank (“ALBK”) has maintained an average Dividend Yield of 4.26 %. The below table lists ALLBANK price and dividend yield for the past 10 years:
Note: 10 year dividend yield is calculated on the basis of the closing price of the share as of the Ex-dividend date (or the Ex-dividend date of the last dividend payment in case the company pays interim dividends). This ensures that the price captured does not reflect the appreciation in share price which results from aggressive buying made by investors before the ex-dividend date in order to become entitled to receive the dividend.
On 9th July 2013, ALBK settled for trade at Rs. 91.60. If you purchased ALBK shares at this price, your dividend yield will be 6.55%, assuming that in future ALBK maintains its rate of dividend (i.e. Rs. 6 per equity share).
Now, what are the chances that ALBK will maintain its rate of dividend? This is where Dividend Payout Ratio demonstrates itself as a great assessment tool.
For FY 2013, ALBK made its highest dividend payout over the past 5 years and yet retained 3/4th of its annual profits.
The table above highlights yet again the point which I had had made earlier. Since ALBK had maintained a low DPR previously, it was able to maintain its rate of dividend in a bad year (I.E. FY 2013) by increasing the payout from 16.07% to 25.32%. Further, a low DPR has helped ALBK accumulate massive reserves over the years. As of 31st March 2013, ALBK had accumulated reserves of Rs. 11,078.20 Cr and a market capitalisation of Rs. 6,325.33 Cr. making it resilient to withstand economic slowdowns. Compare this with another high dividend yielding company – HCL Infosystems (“HCL”).
HCL Infosystems comparison – A High DPR scenario
HCL maintained an average dividend yield of 5.93 % between FY 2003 – FY 2012. The table below shows the dividend yield of HCL for each of these years.
If you notice, for most of these years and in particular from FY 2005 onwards, HCL had an extremely high DPR averaging over 65%. In 2013, when the economy slowed down HCL rightly did not declare any dividend distributions. If you paid close attention to the DPR, Could you have figured this in the earlier years?