An Underrated Superpower

Equity investing has gained popularity among investors through the years for two main reasons. First, it serves as a simple and highly convenient mode of investment. Secondly, equity is a hybrid investment vehicle. That is, long term investors in equity stand to benefit from two sources of returns offered by equities. First, they offer investors regular income in the form of dividends. Second, investors also gain from the increase in the value of their shares over a period of time, which is known as a capital gain or capital appreciation. Obviously, most investors prefer capital gains as their desired mode of return, almost to a point of obsession. But with the obsession around capital gains in equities, we forget that dividends are another aspect and another mode of return from equity investing. So in today’s post I’m going to throw light on how dividends can be just as attractive as a mode of return as capital appreciation is, if not more.

Before going further, let us first gain a basic understanding of what dividends are. Firstly, equity shareholders are owners of the companies whose stocks they own. And, shareholders being owners of a company, dividends are a part of the profits earned by the company that is paid back to the shareholders in return for their ownership of the company. Investing in stocks with constant dividend payouts is underrated, and sometimes even ignored. But if understood well, dividends can be used to push returns from our equity investments up several notches.

Dividends are paid on the face value of a company's shares. And they are paid mainly out of two sources :

° Post tax profits earned by the company, per share of its stock (also known as Earnings Per Share or EPS)

° Free reserves of liquid cash that the company has available on hand

The portion of the EPS or the free cash reserves that is distributed as dividend is known as the the Dividend Payout. When the dividend payout is expressed as a percentage of either of the two sources mentioned above it is called the Dividend Payout Ratio.

Now, let us understand how dividends serve to push up our equity returns. Consider the data given below in the case of an investor who holds 1000 shares of a particular stock who have a constant dividend payout ratio of 50% of their EPS for the year.

So in such a case the investor would recieve dividends worth Rs 5,000 in the first year, Rs 7,500 in the second year and Rs 10,000 in the third year, even though the payout ratio remains constant at 50%. This is because the company is able to grow its profits and EPS consistently from one year to the next. There is also a separate school of investing which propogates the practice of building and holding a portfolio of such companies which constantly grow their earnings and dividend payouts. This is known as Dividend Growth Investing. Dividends and sustainability of dividend payouts are an important determinant of the returns from and the quality of a stock. This is because it is only when earnings are consistently high and cashflows are consistently positive that companies can declare dividends consistently.

Another great thing about dividends is that dividends paid by a company are a function of the corporate policy of the company and not the market perception of the company. Capital appreciation on the other hand is dependent on the both the fundamentals and market perception about the company and its stock, which may keep changing and fluctuating. Dividend returns are therefore a more reliable estimate and steady component of returns relative to capital appreciation. This is even more true during periods of economic downturns when stocks and markets as a whole do not perform well. During such times dividends serve as a cushion for investors to mitigate the effects of falling stock prices.

Dividend receipts may start out being small, but reinvesting dividends to buy more of the stock that paid the dividend increases our holdings in the stock and entitles us to larger dividend receipts in the future. Further, reinvestments would also further magnify the ultimate capital gains from the underlying stocks. Reinvested dividends therefore are a major driver of stock returns. To better understand this, look at the data given below, assuming an investor holds 1000 shares of a stock which pays a constant dividend of Rs 10 per annum

The things to notice here are that the investor always reinvests all the dividends he receives at prevailing market prices which results in him holding more shares and receiving more dividends with each passing year. Also notice that he still receives the same amount of dividend per share even when the market price drops to Rs 150 in year 4.

Dividends also protect the purchasing power of our money under inflationary conditions. Inflation is bad for us as individuals since we would have to pay more for the products and services we consume. But inflation works as a positive for companies since they are likely to raise selling prices for their goods and services. Increased prices mean increased profits, which would in turn mean increased dividend payouts. This means that our money's purchasing power would not be affected much under inflationary conditions, thus taking care of one of our major concerns during periods of inflation.

Until now, dividends were completely tax free in the hands of shareholders. But, a recent ruling by the Indian government has made dividends recieved after 1st April 2020 taxable in the hands of shareholders at applicable slab rates. This apparently makes the prospect of receiving dividends seem less attractive. But remember that dividends are guaranteed receipts in cash which are credited straight to our bank accounts. And what’s not to love about cold hard cash hitting our bank accounts? Ending up with a reduced amount after accounting for tax is better than ending up with no amount at all. Because the tax aspect of any income is just that, one single aspect. And while it is good to save tax on our investments, it should not become an obsession. There is a lot more to our investments than just avoiding taxes. What’s more, dividends can also be used to meet our living expenses when they become large enough. Remember that dividends are our companies' money. So after a point, our companies bear our expenses. Show me a better perk that comes with investing in dividend stocks than that.

It should be clear by now that dividends are not as boring and unattractive as they are made out to be. And while capital gains on our investments are undoubtedly exciting and rewarding, dividends are no slouch themselves. And if used and channeled well dividends can be more effective than capital gains when it comes to pushing up returns from our equity investments. As the old saying in the investment world goes, always buy a chicken for its eggs, a cow for its milk, bees for their honey and stocks for their dividends.