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Friday, June 21, 2013

Dividend Payout Ratio and Dividend Yield

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be distributed to shareholders. 
There are two ways to distribute cash to shareholders:
1) Share repurchases
2) Dividends. 
Many corporations retain a portion of their earnings and pay the remainder as a dividend.

I usually recommend dividend paying stocks (of course after a thorough analysis of the stock) to my followers, primarily because its an handsome tax free cash flow in your hand. 
When you are picking stocks that pay dividends, you might see 2 different dividend values

Both are expressed as percentages. One is called Dividend % (or Dividend Payout Ratio) and the other is called Dividend Yield. It is important to understand the difference between these two values so that you pick up the right stock for you and make an informed decision.

1) Dividend % (or Dividend Payout Ratio) 
This can be high and has nothing to do with the initial share value or anything else. Since Dividends are paid from the earnings or profit of the company, so Dividend Payout Ratio is a simple ratio of Dividend distributed / Profit earned. 
So, if a company earns a profit of Rs. 1,000 in a year, and distributes Rs. 200 out of it as dividends to its shareholders, and the rest Rs. 800 as further investments for business growth, the Dividend Payout Ratio would be Rs. 200 / Rs. 1000 ie 20%. 
This Dividend Payout Ratio does tell you whether a company is keen on growth or on sharing profits but does not tell how much you actually gained on your investment in its stocks.

2) Dividend Yield 
This tells you more closely about the returns that you get on your investment. So, if the dividend declared per share was Rs. 10 and you bought the shares at Rs. 200, your Dividend Yield would be 5% (which is in effect 5% returns in your hand - tax free just from dividends)
So, look out for the right ratios for the right analysis before choosing a stock.

What if Dividend Payout is more than 100%?
If you see Dividend Payout Ratio to be more than 100%, it means that the company is paying you more than the profit it earns per share. This is not a sustainable situation and can happen in extreme circumstances - typically with small cap or unstable companies. Warren Buffet suggests us to try and stay away from instability when investing in stocks.

Cheers

Manoj Arora
Lead a Financially Free Life !!

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