Having dividend paying stocks in the portfolio can be beneficial for investors who are interested in building an alternative stream to raise funds

Companies share their profits with investors by way of dividends. This is one of the reasons why investors invest in stock markets, the other reason being capital appreciation. Dividends can be of two types, cash dividends (made in terms of cash) and stock dividends (investors receive additional shares of stock when a company declares a stock dividend). A firm may opt for stock dividends for a number of reasons, including inadequate cash-in-hand or a desire to lower the price of the stock on a per-share basis to prompt more trading and increase liquidity. The term “stock split” can also apply to stock dividends.

Essentially, dividends mean that an investor gets paid for simply owning the stock. For example, company ‘X’ pays an annualised dividend of Rs 2 per share and if the dividend is paid quarterly, it will pay on-fourth of Rs 2 (50 paise) for each share owned. This may not seem like a huge amount, but when an investor builds a portfolio of thousands of shares, the amount can be high. If an investor uses these dividends to buy more stock in the firm, he/she can make a lot of money. Key is to reinvest the dividends.

Are dividend stocks good investments? As with all investments, dividend stocks aren’t for everyone. However, for some, they can make great additions to an investing portfolio. Dividend paying stocks, which regularly pay out a portion of profits, are generally stable companies. If a firm consistently pays dividends, keeping the yield fairly stable, it is often an indication that it has solid profits year-after-year. Not only will one receive an income stream from such a firm, but the stock price is likely to rise over the course of time, too. However, the stock price of dividend-paying companies may not rise dramatically, so dividends are offered to entice, reward and retain investors. But stable returns can usually be expected over time and many of the best dividend-paying companies see their stock price recover at the end of a stock down cycle. Dividends are great because they provide a revenue stream that an investor can use immediately without selling the stock and their presence can indicate a solid stock investment choice.

Nevertheless, like any other investments, it’s important to perform due diligence prior to making any dividend stock-related decisions. While evaluating investments, it’s important to compare individual companies against industry averages or other similar firms as opposed to unrelated companies. This makes for a more meaningful comparison. Several factors must be considered when researching and selecting dividend stocks, including dividend yield, cover ratio, payout ratio and the company’s history of dividends. Dividend yield shows how much a firm pays in dividends each year relative to its share price. It is calculated by dividing the annual dividend per share by the price per share. It will make sense that the higher the dividend yield, better the investment. But this financial ratio can be deceptive. Remember, dividend yield increases as share price drops. A dividend yield that is unusually higher than other stocks in the same industry may indicate that the stock’s price may drop or that future dividends will be cut or eliminated.

Dividend cover ratio: Is the proportion between a company’s earnings and its net dividend to shareholders, and helps investors analyse if a firm’s earnings are sufficient to cover its dividend obligations as well as determine how sustainable a dividend is. In general, a cover ratio of two or three shows adequate cover and confirms that the firm can afford to pay a dividend. If the ratio falls below two, it may indicate that a dividend cut is on the horizon. If the ratio falls below one, the firm is likely using last year’s retained earnings to cover present dividend. A higher dividend cover (say, four or five) can be seen as a sign that the company has some cushion against future downturns.

Dividend payout ratio: This is the inverse of dividend cover ratio. It indicates the percentage of earnings a company pays out in cash dividends. It is calculated by dividing dividend per share by earnings per share. In general, a firm that pays out less than 50 per cent of its earnings in the form of dividends is considered stable — these companies have the potential to raise earnings over the long term. If a company pays out more than 50 per cent, it may not raise its dividends as much as companies with lower payout ratios and it may have trouble maintaining dividends over the long run.

Overall, having dividend paying stocks in the portfolio can be extremely beneficial for investors who are interested in building an alternative income stream. Investors interested in income diversity can benefit from developing a portfolio that includes dividend paying stocks. These stocks can also be good choices for someone who wants good value and wants to see reasonable growth without a great deal of risk.

(The writer is Assistant Professor at Amity University)