Dividends are liked by almost every investor because it is a great way to get a return on the investment without selling your shares. Dividends are seen like free money which you get just for staying invested in the company. There are many investors who love to invest only in high dividend stocks. But are high dividend stocks good? The answer to the question is that it depends on the factor which is causing the stock to give high dividends. Some high dividend stocks can be good investments whereas some high dividend stocks can be the absolute worst investment!
Stocks are generally categorized into growth stocks and dividend stocks. Growth stocks are typically young and hungry companies which are striving for rapid growth of their business. On the other hand, dividend stocks are typically established companies which act as cash cows for their investors and provide regular returns (often quarterly) in the form of dividends. Investors are looking for capital appreciation (increase in stock price) from growth stocks and regular return (in the form of dividends) from dividend stocks. Both types of stocks serve different purposes with growth stock being the preferred choice for the aggressive (often younger) investor and dividend stocks being the preferred choice for the defensive (often older) investor.
High dividend stocks refer to stocks which have a high dividend yield. The dividend yield of a company is the percentage ratio of the annual dividend and the stock price. Suppose a stock which is trading at a CMP (current market price) of Rs. 100 pays an annual dividend of Rs. 5, then the dividend yield becomes 5%.
Dividend Yield = (Annual Dividend / Stock price)*100
It means that the company paid 5% of the investor’s capital back in the form of dividends in a year. Typically any company which has a dividend yield of more than 4% is considered to be high dividend stocks. To analyze whether a high dividend stock is good or bad, we need to consider the factors which can lead to a stock having a high dividend yield.
There are three ways in which a stock can have high dividend yield
- The dividend paid out by the company increases
- The stock price of the company decreases
- Both increasing dividends & falling stock price
Either (or both) of these changes can cause the dividend yield of a stock to increase. Let’s analyze both cases in detail.
Increase in dividends
The increase in dividends paid generally happens when a company makes big profits in a quarter. This dividend can be paid out in the form of a quarterly dividend or a special dividend (or sometimes both). An increase in dividend with the stock price remaining the same is generally great for investors because it shows that the company is sharing it’s profits with the investors. A continuous increase in dividends is also experienced in well established companies which do not have much scope for growth & reward the shareholders for holding the company shares. A company which is both growing & has increasing dividends is a dream come true because such a company is absolutely great for investment! However, these kinds of companies often trade at very high valuations. To learn more about why some companies trade at high P/E ratio, visit this article!
If the dividend yield is very high, the share price of the company will rise over time to make the dividend yield low again. It doesn’t make sense for a company to have a dividend yield of over 5% when the Fixed Deposit in a bank has a rate of return that is under 5%. A rise in price is almost certain in such a situation. If the price of the company is not rising to compensate for the growth in dividends or even worse, the price of the stock is falling, this brings us to the other factor which can cause an increase in dividend yield.
Falling stock price
Apart from rising dividends paid by the company, another reason which can lead to higher dividend yield is the falling price of the stock. If a stock price falls from Rs. 100 to Rs. 50, then the dividend yield of the company will simply double. This is a big concern for investors because this shows that the company is not growing (it might even be shrinking). A business which is not growing always gets punished in the stock market because every single investor is looking for the growth of the company. It also shows that the company is more focused in siphoning out the cash in the form of dividends rather than building the company as promoters are more concerned to pull out money from a failing company. Such a company should not be on the watchlist of long term investors because increase in dividend yield doesn’t have any meaning if the price of the stock keeps on falling!
Rising dividends and falling stock prices
This is a combination of both factors which can cause a huge increase in the dividend yield of any stock. This is generally a bad sign because it clearly shows that the promoters of the company are interested in getting the money out of the business even if it leads to a reduction of value of the business. This also shows that the company has absolutely no plans for expansion & future growth because all of the profits are taken out of the company to pay the investors. These are generally signs of a dying business which long term investors should definitely avoid!
Conclusion
A high dividend stock can be either a growing business or a fading business depending on which parameter of the dividend yield is changing. Investors should always go after the growth of the business because a dying business will always lead to capital depreciation (fall in share price). In most cases, the high dividend is not enough to compensate for the capital loss due to falling stock price. A high dividend company which has a growing business should always be the focus for long term investors.
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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